Back to GetFilings.com

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

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

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

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      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 amendment to this Form 10-K. 

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

The aggregate market value of the voting stock held by nonaffiliates of the Registrant as of February 28, 2004, (based upon the bid price of these shares on NASDAQ on such date) was $22,741,844.

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

1

Table of Contents

2

Note Regarding Forward-Looking Statements

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

3

The National Security Group, Inc.

PART I

Item 1. Business

Summary Description of The National Security Group, Inc.

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

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

Industry Segment and Geographical Area Information

Property and Casualty Insurance Segment

The Company’s property and casualty insurance business is conducted through National Security Fire & Casualty Company (NSFC), a wholly owned subsidiary of the Company organized in 1959, and Omega One Insurance Company (Omega), a wholly owned subsidiary of National Security Fire & Casualty Company organized in 1992. This segment will be referred to throughout this report as NSFC, Omega, property and casualty segment or P&C segment. NSFC is licensed to write insurance in the states of Alabama, Arkansas, Florida, Georgia, Mississippi, Oklahoma, South Carolina, and Tennessee, and operates on a surplus lines basis in the states of Louisiana, Missouri, and Texas. Omega is licensed to write insurance in Alabama and Louisiana. The following table indicates allocation percentages of direct written premium by state for the three years ended December 31, 2004, 2003 and 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 vary from policy to policy, but are typically in the range of $250 to $500 on NSFC and Omega’s primary dwelling and automobile lines of business.

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

4

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

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

Property and Casualty Loss Reserves

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

While the information in the table provides a historical perspective on the adequacy of unpaid losses and loss adjustment expenses established in previous years, it should not be assumed to be predictive of redundancies or deficiencies on current year unpaid losses in future periods. Company management believes that the reserves established at the end of 2004 are adequate. However, due to inherent uncertainties in the loss reserve estimation process, management cannot assert that current year reserve balances will prove to be adequate. Due to the short tail nature of the property and casualty subsidiaries claim liabilities, the Company does not discount loss reserves for the time value of money. Dollar amounts are in thousands.

5

6

Life Insurance Segment

National Security Insurance Company (NSIC), a wholly owned subsidiary organized in 1947, conducts the Company’s life insurance business. This segment will be referred to throughout this report as NSIC, Life Company, or Life segment. NSIC is licensed to write insurance in six states: Alabama, Florida, Georgia, Mississippi, South Carolina, and Texas. The following table indicates NSIC’s percentage of direct premiums collected by state for the three years ended December 31, 2004, 2003 and 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 50% of total premium revenues in the life insurance segment. Home service life products consist of products marketed directly at the home or other premises of the insured by an employee agent. The Company employed 17 home service agents at December 31, 2004. The independent agent distribution method accounts for 41% of total premium revenue in the life insurance segment. Since NSIC began marketing life, accident and health products through independent agents in 1999 the distribution channel has become the fastest growing method of distribution. The Company had approximately 624 agents that had new business production during 2004. The remaining 9% of premium revenue consists of the following: an acquired book of premium from a state guaranty association in 2000 (4%), premium generated through direct sales of school accident insurance (3%), and other miscellaneous business serviced directly through the home office.

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

The following table displays a break down of 2004 life segment premium produced by product and distribution method (dollars in thousands):

7

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

Investments

Investment income is a significant portion of the Company’s total income. Assets that will eventually be used to pay reserve liabilities and other policyholder obligations along with Company capital are invested to generate investment income while held by the Company. Investment income is comprised primarily of interest and dividend income on debt and equity securities and realized capital gains and losses generated by debt and equity securities. For 2004, investments comprise 76% of total assets and investment income (including realized gains) comprises 11% of total revenues evidencing the significant impact investments can have on financial results. As the Company’s insurance subsidiaries are regulated as to the types of investments that they may make and the amount of funds they may maintain in any one type of investment, the Company has developed a conservative value oriented investment philosophy, which meets regulatory requirements. The central theme of the Company’s investment philosophy is to conserve capital resources and assets while meeting the investment requirements of its reserves and providing a reasonable return on investments. This return is generated through current yield from invested assets as well as capital appreciation of investments.

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

8

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

The Company guarantees Mobile Attic debt totaling $13.1 million. Additional details of investments, including further discussion on the operations of Mobile Attic are discussed in detail in the accompanying management’s discussion and analysis.

Marketing and Distribution

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

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

Agents receive compensation for their sales efforts. In the case of life insurance agents, compensation is paid in the form of sales commissions plus a servicing commission. Commissions paid by NSIC in 2004 averaged approximately 23% of premiums. Commissions paid by the NSFC in 2004 averaged approximately 18% of premiums. During 2004, no one independent agent accounted for more than 10% of total net earned premium of the property-casualty insurance subsidiaries. NSFC also offers a “profit sharing bonus plan” to independent agents in order to promote better field underwriting and encourage retention of profitable business. This plan not only rewards our agents but also enhances profitability by giving the agent a vested interest in our success and also aids in maintaining price stability for all our customers as agents have a financial incentive to use good field underwriting practices when completing an application for insurance.

At December 31, 2004 NSIC employed 17 home service agents and one manager. NSIC also had approximately 624 independent agents actively producing new business.

At December 31, 2004 NSFC had contracts with approximately 1,335 independent agents in twelve states.

Risk Management

Underwriting

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

9

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

Reinsurance

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

NSIC generally reinsures all risks in excess of $50,000 with respect to any one insured. NSFC and Omega generally reinsure with third parties any liability in excess of $150,000 on any single policy. In addition, the property-casualty subsidiaries have catastrophe excess reinsurance, which provided protection in part with respect to aggregate property losses arising out of a single catastrophe, such as a hurricane. In 2004, the property-casualty subsidiaries had catastrophe protection up to a $35 million loss. Under the property and casualty subsidiaries reinsurance arrangement in force during 2004, the Company retained the first $2 million of insured losses from any single catastrophic event. The next $15.5 million in insured losses from any single event was 95% reinsured with the Company’s net retention being 5%. The final layer of reinsurance protection provided coverage for 100% of insured losses exceeding $17.5 million and up to $35 million. The amount of catastrophe reinsurance protection purchased by the Company was based on computer modeling of actual Company exposure. The Company generally seeks protection for worst case scenarios based on the computer modeling that mitigates losses up to a 1 in 250 year event, that is a loss that has less than a ½ of 1% chance of occurring in any given year. NSFC and Omega had a provision for one reinstatement (coverage for two catastrophic events) during 2004. In addition to catastrophe reinsurance, NSFC also had a 60% quota share reinsurance agreement on ocean marine exposure with additional excess of loss coverage.

Reserve liabilities

NSIC maintains life insurance reserves for future policy benefits to meet future obligations under outstanding policies. These reserves are calculated to be sufficient to meet policy and contract obligations as they arise. Liabilities for future policy benefits are calculated using assumptions for interest, mortality, morbidity, expense, and withdrawals determined at the time the policies were issued. As of December 31, 2004, the total reserves of NSIC (including the reserves for accident and health insurance) were approximately $24 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

10

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, 2004, the property-casualty subsidiaries had reserves for unpaid claims of approximately $13.1 million before subtracting unpaid claims, which will be due from reinsurers of $2.6 million leaving net unpaid claims of $10.5 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, 2004, 2003 or 2002. The Company believes such reserves are adequate to provide for settlement of claims. Employees of the Company calculate NSFC and Omega loss reserves. Milliman, Inc. an independent actuarial consulting firm, reviews loss reserve estimates and issues a Statement of Actuarial Opinion regarding the adequacy of reserves.

Financial Ratings

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

Regulation

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

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

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

Competition

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

11

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

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

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

Inflation

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.

Employees 

The Company has no management or operational employees. Subsidiary National Security Insurance Company employs all employees. The Company and its property and casualty subsidiary have a Management Service Agreement (“Agreement”) with the National Security Insurance Company whereby the Company and the property and casualty subsidiary reimburse NSIC for salaries and expenses of employees provided under the Agreement. Involved are employees in the areas of Underwriting, Customer Service, Policy Services, Accounting, Marketing, Administration, Imaging, Data Processing, Programming, Personnel, Claims, and Management. The Company, through NSIC, was represented by 17 employee agents in Alabama. The Company’s property and casualty subsidiaries had over 1300 independent agents at December 31, 2004. The Company believes its employee relations are good.

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

The Company maintains a website (www.nationalsecuritygroup.com). The National Security Group, Inc.’s annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to such reports that we file or furnish pursuant to Section 13(a) of the Securities Exchange Act of 1934 are available through our Internet website, free of charge, as soon as reasonably practical upon having been electronically filed or furnished to the Securities and Exchange Commission. The Company’s code of ethical conduct is also available on our website and in print to any stockholder who requests copies by contacting The National Security Group, Attn: Investor Relations, P. O. Box 703, Elba, AL 36323. The Company’s periodic reports filed with the SEC, which include Forms 3, 4 and 5, Form 10-K, Form 10-Q, Form 8-K and any amendments thereto may also be accessed free of charge from the SEC’s website at www.sec.gov. Additional information about the Company’s 50% owned subsidiary, The Mobile Attic, Inc., can be found on its website www.mobileattic.com.

12

Item 2. Properties

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

Item 3. Legal Proceedings

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

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

There were no matters submitted to a vote of security holders during the three months ended December 31, 2004.

13

PART II

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

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

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

Shareholders

The number of shareholders of the Company’s capital stock as of January 31, 2005, was approximately 1,100.

Dividends

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

Discussion regarding dividend restrictions may be found on page 23 of the Managements’ Discussion and Analysis as well as in Note 12 of the consolidated financial statements.

14

Item 6. Selected Financial Data

15

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

OVERVIEW

The following discussion highlights significant factors influencing the consolidated financial position and results of operations of The National Security Group, Inc. (referred to in this document as we, our, us, the Company or NSEC) and its subsidiaries for the three years ended December 31, 2004. This discussion and analysis of the consolidated results of operations and financial condition of the Company should be read in conjunction with the Selected Financial Data and Consolidated Financial Statements and related notes included elsewhere herein. Please refer to our note regarding forward-looking statements on page 3 of this report.

The following are two words that will appear almost chronically throughout this discussion: Hurricane Ivan. Losses resulting from the impact of Hurricane Ivan significantly influenced the financial results for the year ended December 31, 2004. While total losses were mitigated through risk management using catastrophe excess of loss reinsurance; the Company’s share of total losses and catastrophe reinsurance reinstatement premium reduced net income by over $3,600,000.

RESULTS OF OPERATIONS

The following analysis of the Results of Operations should be read in conjunction with the Consolidated Financial Statements, which begin on Page 28 of this Form 10-K. Primary reference is made to the Consolidated Statements of Income on page 29 and segment information provided in Note 14 to the Consolidated Financial Statements.

Consolidated Results of Operations:

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

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

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

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

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

Year Ended December 31, 2003 Compared to Year Ended December 31, 2002

Premium revenue reached a record high (eclipsed in 2004) of $47,536,000 in 2003, an increase of 45.3% over 2002 premium revenue of $32,631,000, a previous Company record. Continued strong growth in the property and casualty insurance segment was the primary catalyst contributing to the increase in premium revenue. Property and casualty premium revenue totaled $41,737,000 in 2003 compared to $27,236,000 in 2002. Strong growth in dwelling property lines of business, particularly homeowners type products, were the major contributor to the increase in property and casualty premium revenue. The life, accident and health segment continued to increase premium revenue at a healthy pace with a 7.5% increase over 2002.

16

Consolidated net income for the Company was $4,090,000 in 2003 compared to $908,000 in 2002. On a per share basis earnings were $1.66 in 2003 compared to $.37 in 2002. Realized capital gains in 2003 were $1,420,000 compared to $1,170,000 in 2002. Pre-tax earnings were $5,600,000 in 2003 compared to $1,500,000 in 2002. A much improved property and casualty combined ratio in the property and casualty subsidiaries was the primary factor contributing to the significant increase in the segments pre-tax earnings. The improvement in the property and casualty combined ratio is discussed further in the segment information presented below. The life, accident and health insurance segment experienced a 50% decline in pre-tax earnings primarily due to litigation related cost, which is discussed further in Note 15 to the consolidated financial statements.

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

Industry Segment Data

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

Income before taxes and minority interest:

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

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, 2004 Compared to Year Ended December 31, 2003:

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

17

Premium revenue increased to $6,173,000 in 2004 compared to $5,799,000 in 2003, an increase of 6.5%. Premium revenue produced by independent agents totaled $2,537,000 in 2004 compared to $2,186,000 in 2003, a 16% increase. While NSIC is continuing to focus on growth through the independent agent method of distribution, we will begin to shift to an increased focus on quality. For the past five years, NSIC has worked to establish a position in the independent agent market. In the process of establishing this position, NSIC has had very low thresholds for business production and persistency. NSIC had appointments with over 1,828 independent agents at the end of 2004 but only 33% of agents appointed actually produced any new business. Management will begin to place more stringent performance standards on agents beginning in 2005 including higher production standards and higher expectations of persistency of business. These changes will no doubt greatly reduce the number of total agency appointments when fully implemented, but should improve quality and profitability of business produced. Premium revenue produced by NSIC home service agency force increased slightly in 2004 to $2,996,000 from $2,970,000 in 2003. Due to changing market conditions, the home service market is not considered to be a growth market, but the Company intends to maintain a niche in this market to serve our current policyholders that prefer this method of service. At December 31, 2004 NSIC had 17 home service agents that serviced this book of business.

Commission expense, including field servicing cost from the home service method of distribution, as a percent of premium revenue declined 3.4 percentage points in 2004 compared to 2003. Commission expense totaled 37% of revenue in 2004 compared to over 40% in 2003. Life insurance commission rates for independent agents are typically front loaded meaning that higher commissions are paid in the early years of a policy and commission rates decline as the policy ages. Because the independent agent method of distribution is a relatively new method of distribution, overall commission rates are skewed higher because the majority of in force policies are still paying the higher commission rates of the early years. Management is continuing to focus on reducing commissions through improving the rate of retention of new and existing business.

Year Ended December 31, 2003 Compared to Year Ended December 31, 2002:

Income before income taxes in 2003 was $529,000 compared to $1,082,000 in 2002. Litigation related expenses decreased pretax earnings by over $565,000 and was the primary factor contributing to the 50% decline in pre-tax earnings. Pending litigation against NSIC is discussed further in Note 15 to the consolidated financial statements.

Premium revenue increased to $5,799,000 in 2003 compared to $5,395,000 in 2002, an increase of 7.5%. Insurance sales through independent agent distribution channels increased over 32% in 2003 over prior year; while sales through NSIC’s traditional home service distribution channel declined by 7%.

Commission expense increased 5.7% in 2003 compared to 2002. 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.

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, 2004 Compared to Year Ended December 31, 2003:

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

18

Income before income tax declined considerably in 2004 to $4.22 million compared to $ 5.72 million in 2003. As discussed earlier, results for 2004 were negatively impacted by losses and adverse claims experience related to hurricane losses in the third quarter of 2004. Claims frequency increased significantly in 2004 compared to 2003 with claims on dwelling lines of business (homeowners and dwelling fire) exceeding 12,500 claims compared to 5,100 claims in 2003. Over 7,500 claims were reported from Hurricane Ivan so without the impact of Ivan, claims frequency was in line with 2003 total of around 5,000 claims. Average severity on dwelling claims in 2004 declined to an average of $2,900 compared to $3,600 in 2003. Average severity declined primarily due to the large volume of Hurricane Ivan claims. Because most of the losses from Hurricane Ivan were inland and limited primarily to minor wind damage, claims from Ivan averaged less than $2,000 per occurrence, which skewed 2004 average severity downward. Hurricanes typically cause higher number of claims (frequency) and a lower average cost per claim (severity) than tornado related losses. Tornadoes tend to affect a more isolated area and therefore have a lower frequency but typically cause more structural damage including a higher proportion of total losses therefore severity is greater from tornado losses. Non-catastrophe related dwelling losses typically have an average per loss severity in the $3,500 to $4,000 range for the P&C subsidiaries.

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

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

Year Ended December 31, 2003 Compared to Year Ended December 31, 2002:

Property and casualty premium revenues increased $14,905,000 for the year ended December 31, 2003 compared to the same period in 2002, an increase of over 45.7%. The acquisition of a book of business contributed nearly $3,000,000 to the total increase in premium revenue. Increased production in the homeowners line of business added nearly $5,000 000 in increased premium revenue. NSFC’s traditional dwelling fire line of business grew over 32% during the year and added nearly $5,000,000 in premium revenue.

Net income before income tax was $5,628,000 in 2003 compared to $1,470,000 in 2002. Pre-tax income increased significantly over 2002. Results for 2002 were negatively impacted by adverse claims experience from hurricane losses in the fourth quarter of 2002 and an increased severity of losses on new business issued. Results for 2003 were much improved due to decreases in both severity and frequency of losses. Average severity on dwelling property claims declined from nearly $4,000 per loss in 2002 to $3,600 per loss in 2003. Prior year growth also helped 2003 results as a larger book of renewal business helped significantly reduce NSFC loss ratios. Typically, insurance business issued within one year has a higher occurrence of losses than renewal business. Due to the rapid growth the P&C subsidiaries have experienced over the last three years, larger amounts of new business have led to higher loss ratios as was demonstrated in 2002. Typically, as renewal books of business grow and the rapid growth of new business moderates, loss ratios improve.

19

Property & Casualty Combined Ratio:

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

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 2004 compared to 2003 increased 8.8 percentage points. This increase was entirely due to losses incurred from Hurricane Ivan. Hurricane Ivan added 8.9 percentage points to the combined ratio for 2004.

The combined ratio for 2003 compared to 2002 declined 16.6 percentage points due to much improved underwriting results on the dwelling lines of business in the P&C subsidiaries. A $400 decline in average severity discussed in the preceding property and casualty segment information along with a drop in frequency relative to premium volume were the primary factors contributing to the decline in the combined ratio in 2003 compared to 2002.

Leasing operations:

The Company’s leasing operations are conducted through its 50% owned subsidiary, Mobile Attic, Inc. Mobile Attic was incorporated in August of 2001 and is a joint venture with a manufacturing partner, Cash Brothers Leasing of Elba, Alabama. As detailed in Note 1 (a) of the consolidated financial statements on page 34, the Company consolidated its investment in the subsidiary Mobile Attic, Inc.

Mobile Attic is in the business of leasing portable storage containers to individual and commercial customers through franchises and an independent dealer network currently covering Alabama and expanding throughout the Southeastern United States. At December 31, 2004 there were 14 franchise locations throughout the Southeast and 13 dealerships. At December 31, 2004 Mobile Attic had available approximately 3,500 storage containers for lease through franchise and dealer locations. The portable storage containers are eight feet wide and eight feet tall and are available in lengths of 8, 16, 20, and 40 feet. Independent dealers market these portable storage containers primarily to household customers in need of a convenient alternative to fixed location mini-storage, commercial customers in need of secure storage facilities at job sites, and retail customers for storage of seasonal inventory.

20

Mobile Attic began the steps to franchise its business model during 2004. Expansion through this new avenue will allow Mobile Attic to venture more rapidly into new areas and expand into larger cities while significantly reducing future capital requirements. Mobile Attic began selling franchised locations in the first quarter of 2004.

In 2004 Mobile Attic generated a $211,000 net loss. The business generated positive cash flow for the year, but a decrease in revenues from dealership sales fees and utilization fees below expected ultimate levels generated an operating loss for the year. The Mobile Attic discontinued the sales of dealerships in 2003 in anticipation of a change in strategy of growing Mobile Attic through a franchise system, which began in the third quarter of 2004. Mobile Attic completed the build out of company owned storage units in late 2004 and as the utilization rates on these units increase, cash flow and profits will improve significantly.

Net income in 2002 was $136,000 and primarily driven by the addition of several dealers during the year, thus increasing dealer fee revenue. In 2001, the year in which operations began, gross rental revenues were $87,000. In 2004, gross revenues from leasing operations were $2,459,000. Mobile Attic expects to add over 50 franchise locations during 2005.

Asset Portfolio Review:

The life insurance and property/casualty subsidiaries primarily invest in highly liquid investment grade debt and equity securities. At December 31, 2004, the company’s holdings in debt securities amounted to 73.4% of total investments and 55.3% 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 4 to the consolidated financial statements).

The insurance subsidiaries’ fixed maturity securities include mortgage-backed bonds, primarily collateralized mortgage obligations (CMO’s), of $8.7 million and $7.8 million at December 31, 2004 and 2003 respectively. The mortgage-backed bonds are subject to risks associated with variable prepayments of the underlying mortgage loans. Prepayments cause those securities to have different actual maturities than that expected at the time of purchase. Securities that are purchased at a premium to par value and prepay faster than expected will incur a reduction in yield or loss. Securities that are purchased at a discount to par value and prepay faster than expected will generate an increase in yield or gain. The degree to which a security is susceptible to either gains or losses is influenced by the difference between amortized cost and par value, the relative sensitivity of the underlying mortgages backing the assets to prepayments in a changing interest rate environment and the repayment priority of the securities in the overall securitization structure. In order to minimize risk associated with prepayments on collateralized mortgage obligations, the Company typically invests primarily in more predictable planned amortization class (PAC) structures of CMO’s and typically avoids investment in CMO’s priced at significant premiums above par value.

21

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

Maturity Schedule (Amounts in thousands)

Liquidity and Capital Resources: Due to increased claims from Hurricane Ivan, the Company sold approximately $2 million of primarily short-term securities to fund the payment of hurricane claims. Consequently, the amount of securities with maturities of less than one year declined below normal levels causing a temporary asset/liability mismatch. However, due to the large percentage of the fixed maturity portfolio with maturities ranging from 1 to 5 years, the mismatch can be corrected in short order with no material impact on earnings, liquidity or capital resources.

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

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

The National Security Group’s and consolidated statement of cash flows indicate that operating activities provided cash of $886,000, $11,398,000, $5,189,000 in 2004, 2003, and 2002 respectively. The significant decline in cash flow from operating activities in 2004 compared to 2003 was primarily due to the significant increase in claims associated with Hurricane Ivan. Cash flow in 2003 compared to 2002 was significantly improved primarily due to the previously discussed improvement in the property and casualty subsidiaries combined ratio.

22

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

Contractual Obligations and Commitments

Long-term debt obligations include $2,731,000 in debt held directly by the Company. It is anticipated that this debt will be retired in 2007. Long-term debt obligations also include $13,105,000 in debt held by a 50% owned subsidiary, The Mobile Attic. The current debt obligation of Mobile Attic matures in 2007, but it is currently anticipated that Mobile Attic will seek to refinance approximately 50% of this debt under a longer term financing prior to maturity.

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

The ability of the Company to meet its commitments for timely payment of claims and other expenses depends, in addition to current cash flow, on the liquidity of its investments. On December 31, 2004, the Company had no known impairments of assets or changes in operation, which would have a material adverse effect upon liquidity. Approximately 85% of the Company’s insurance subsidiary assets are invested in cash; investment grade fixed income securities, short-term investments and broadly traded equity securities, which are highly liquid. The values of these investments are subject to the conditions of the markets in which they are traded. Past fluctuations in these markets have had little effect on the liquidity of the Company. The Company has relatively little exposure to lower grade fixed income investments which might be especially subject to liquidity problems due to thinly traded markets.

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

As disclosed in Note 12 to the consolidated financial statements, in 2004, the amount that The National Security Group’s insurance subsidiaries can transfer in the form of dividends to the parent company is limited to $1,029,000 million in the life insurance subsidiary and $2,376,000 million in the property/casualty insurance subsidiary. However, that condition poses no short-term or long-term liquidity concerns for the parent company.

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

23

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

The levels and ratios are as follows:

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 3.6 to 1 at December 31, 2004.

National Security Insurance Company (life insurer) has regulatory adjusted capital of $11.45 million and $11.37 million at December 31, 2004 and 2003, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 14.0 and 16.0 at December 31, 2004 and 2003 respectively. Accordingly, National Security Insurance Company exceeds the minimum RBC requirements.

National Security Fire & Casualty Company (property/casualty insurer) has regulatory adjusted capital of $23.7 million and $23.1 million at December 31, 2004 and 2003, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 3.6 and 4.0 at December 31, 2004 and 2003 respectively. Accordingly, National Security Fire & Casualty Company exceeds the minimum RBC requirements.

Omega One Insurance Company (property/casualty insurer), which began writing business in late 1995, has regulatory adjusted capital of $7.6 million and $6.7 million at December 31, 2004 and 2003, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 12.3 and 9.3 at December 31, 2004 and 2003 respectively. Accordingly, Omega One Insurance Company exceeds the minimum RBC requirements.

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

24

Reinsurance

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

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

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

At December 31, 2004, the estimated reinsurance recoverable recorded was $3,318,000. The Company does not anticipate any issues with collection of the recorded amount.

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

There is a possibility that the actual amounts recovered from reinsurers could be materially less than the estimates recorded. This possibility could result in a material adverse impact on our financial condition and results of operations. Reinsurers may dispute claims under reinsurance treaties, such as the calculated amount of reinsurance recoverable.

NSIC generally reinsures all risks in excess of $50,000 with respect to any one insured. NSFC and Omega generally reinsure with third parties any liability in excess of $150,000 on any single policy. In addition, the property-casualty subsidiaries have catastrophe excess reinsurance, which protects it in part with respect to aggregate property losses arising out of a single catastrophe, such as a hurricane. In 2004, the property-casualty subsidiaries had catastrophe protection up to a $35 million loss. Based on a evaluation using actual NSFC and Omega exposures and catastrophe modeling based on a 250 year loss, that is a loss that has a less than ½ of 1% chance of occurring in any given year, the property and casualty subsidiaries would pay $2.7 million in losses and reinsurers would pay $36.8 million.

In addition to catastrophe reinsurance, NSFC also had a 60% quota share reinsurance agreement on ocean marine exposure with additional excess of loss coverage.

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

Deferred Policy Acquisition Costs

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

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

25

At December 31, 2004, we had recorded $6,217,000 as an asset for DAC in our financial statements. For more information regarding deferred policy acquisition costs, please see Note 1 to our financial statements.

Deferred Income Taxes

Deferred income taxes are created when there are differences between assets and liabilities for tax and financial reporting purposes, as well as tax credits, net operating losses and other carryforwards. SFAS 109 “Accounting for Income Taxes,” requires that deferred tax assets be reduced by a valuation allowance if, based on the available evidence, it is more likely than not that all of the recorded deferred tax assets will not be realized in future periods. This standard requires management to exercise judgment in determining whether or not the deferred tax asset is realizable.

At December 31, 2004 there is no evidence to suggest to management that the deferred tax asset is unrealizable. For more information regarding deferred income taxes, please see Note 7 to our financial statements.

Valuation of Investments

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

At December 31, 2004 there were no other-than-temporary impairments. For more information regarding valuation of investments, see Note 1 to our financial statements.

Loss and Loss Adjustment Expense

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

At December 31, the recorded liability for loss and loss and adjustment expense was $13,094,000. For more information regarding loss and loss adjustment expense, see Note 9 to our financial statements.

26

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 $20.2 million. If the market value of the S & P 500 Index decreased 10% from its December 31, 2004 value, the fair value of the Company’s common stock would decrease by approximately $2.1 million.

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

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

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

As for shifts in investment allocations, the major shift has been a move away from corporate bonds and into government agency issues. Corporate spreads have remained extremely tight relative to agency securities. Due to the tight interest rate spreads, the investment committee has not felt compelled from a risk/reward standpoint to increase or maintain the allocation to corporate bonds. Corporate bonds now compose just 15.3% of bond investments compared to over 26.5% last year. In contrast, government securities, primarily agency issues, compose 67.5% of bond investments compared to 52.8% last year. The allocation to collateralized mortgage obligations, which primarily consists of planned amortization class structures, remains virtually unchanged from last year. The Company does not anticipate any further major shifts in fixed income investment allocations in the near future.

27

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.

28

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

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

We have audited the accompanying consolidated balance sheets of The National Security Group, Inc. and subsidiaries as of December 31, 2004, 2003 and 2002, 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, 2004. Our audits also included the financial statement schedules listed in the Index at page 28. These consolidated financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits.

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

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of The National Security Group, Inc. and subsidiaries as of December 31, 2004 and 2003, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the financial statement schedules listed in the Index at page 28, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.

/S/ Barfield, Murphy, Shank, & Smith

Birmingham, Alabama
February 25, 2005

29

THE NATIONAL SECURITY GROUP, INC.

CONSOLIDATED STATEMENTS OF INCOME

See accompanying notes to consolidated financial statements

30

The National Security Group, Inc.

CONSOLIDATED BALANCE SHEETS

See accompanying notes to consolidated financial statements

31

THE NATIONAL SECURITY GROUP, INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY