NATIONAL SECURITY GROUP INC - FORM 10-Q

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EXCEL - IDEA: XBRL DOCUMENT - NATIONAL SECURITY GROUP INC	Financial_Report.xls
EX-31.1 - EXHIBIT 31.1 - NATIONAL SECURITY GROUP INC	exhibit3116-30x2014.htm
EX-31.2 - EXHIBIT 31.2 - NATIONAL SECURITY GROUP INC	exhibit3126-30x2014.htm
EX-32.1 - EXHIBIT 32.1 - NATIONAL SECURITY GROUP INC	exhibit3216-30x2014.htm

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)



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

For Quarterly Period Ended June 30, 2014



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

For the transition period from to .

Commission File Number 0-18649

The National Security Group, Inc.

(Exact name of registrant as specified in its charter)



Delaware		63-1020300
(State or Other Jurisdiction of Incorporation or Organization)		(IRS Employer Identification No.)

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

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

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

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

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

As of August 13, 2014, there were 2,507,452 shares, $1.00 par value, of the registrant’s common stock outstanding.

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THE NATIONAL SECURITY GROUP, INC.

INDEX



PART I. FINANCIAL INFORMATION
			Page No.
	Item 1. Financial Statements

		Condensed Consolidated Balance Sheets	4
		Condensed Consolidated Statements of Income	5
		Condensed Consolidated Statements of Comprehensive Income (Loss)	6
		Condensed Consolidated Statements of Changes in Shareholders’ Equity	7
		Condensed Consolidated Statements of Cash Flows	8
		Notes to Condensed Consolidated Financial Statements	9
		Review Report of Independent Registered Public Accounting Firm	31

	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		32

	Item 3. Quantitative and Qualitative Disclosures about Market Risk		42

	Item 4. Controls and Procedures		43


PART II. OTHER INFORMATION

	Item 1. Legal Proceedings		43
	Item 1A. Risk Factors		43
	Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		43
	Item 3. Defaults Upon Senior Securities		43
	Item 4. Mine Safety Disclosures		43
	Item 5. Other Information		43
	Item 6. Exhibits		43


SIGNATURE			45

Table of Contents

Cautionary Statement Regarding Forward-Looking Statements

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


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


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


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


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


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


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

▪

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

▪

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

▪

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


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

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Part I. Financial Information

Item 1. Financial Statements

THE NATIONAL SECURITY GROUP, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS (In thousands)



	June 30, 2014		December 31, 2013
	(UNAUDITED)
ASSETS
Investments
Fixed maturities held-to-maturity, at amortized cost (estimated fair value: 2014 - $783; 2013 - $853)	$	728	$	812
Fixed maturities available-for-sale, at estimated fair value (cost: 2014 - $81,984; 2013 -$79,074)	85,092		79,434
Equity securities available-for-sale, at estimated fair value (cost: 2014 - $2,420; 2013 - $2,420)	4,888		4,374
Trading securities	19		19
Mortgage loans on real estate, at cost	229		333
Investment real estate, at book value	4,288		4,218
Policy loans	1,480		1,443
Company owned life insurance	5,996		5,858
Other invested assets	3,478		3,559
Total Investments	106,198		100,050
Cash	6,179		4,987
Accrued investment income	802		817
Policy receivables and agents' balances, net	12,176		10,276
Reinsurance recoverable	789		1,501
Deferred policy acquisition costs	8,960		8,776
Property and equipment, net	1,991		2,077
Accrued income tax recoverable	—		6
Deferred income tax asset, net	3,609		4,654
Other assets	2,563		836
Total Assets	$	143,267	$	133,980
LIABILITIES AND SHAREHOLDERS' EQUITY
Property and casualty benefit and loss reserves	$	9,328	$	8,734
Accident and health benefit and loss reserves	2,694		2,651
Life and annuity benefit and loss reserves	31,163		30,696
Unearned premiums	30,512		27,301
Policy and contract claims	896		842
Other policyholder funds	1,483		1,447
Short-term notes payable and current portion of long-term debt	1,166		1,866
Long-term debt	21,164		20,889
Accrued income taxes	52		—
Other liabilities	6,441		6,082
Total Liabilities	104,899		100,508
Contingencies
Shareholders' equity
Common stock	2,508		2,495
Additional paid-in capital	5,267		5,147
Accumulated other comprehensive income	2,915		936
Retained earnings	27,678		24,894
Total Shareholders' Equity	38,368		33,472
Total Liabilities and Shareholders' Equity	$	143,267	$	133,980

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

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THE NATIONAL SECURITY GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

(In thousands, except per share amounts)



	Three months ended June 30,					Six months ended June 30,
	2014			2013		2014		2013
REVENUES
Net premiums earned	$	14,100		$	13,038	$	27,924	$	25,972
Net investment income	1,030			689		1,978		1,734
Net realized investment gains	312			1,030		400		1,057
Other income	1,713			145		1,867		317
Total Revenues	17,155			14,902		32,169		29,080
BENEFITS, LOSSES AND EXPENSES
Policyholder benefits and settlement expenses	9,155			8,260		17,019		17,811
Amortization of deferred policy acquisition costs	873			923		1,771		1,865
Commissions	1,967			1,486		3,994		3,468
General and administrative expenses	2,413			2,162		4,439		3,965
Taxes, licenses and fees	521			474		1,051		960
Interest expense	382			435		768		877
Total Benefits, Losses and Expenses	15,311			13,740		29,042		28,946

Income Before Income Taxes	1,844			1,162		3,127		134

INCOME TAX EXPENSE (BENEFIT)
Current	80			88		168		220
Deferred	(170		)	109		26		(642		)
	(90		)	197		194		(422		)

Net Income	$	1,934		$	965	$	2,933	$	556

INCOME PER COMMON SHARE BASIC AND DILUTED	$	0.77		$	0.39	$	1.18	$	0.23

DIVIDENDS DECLARED PER SHARE	$	0.03		$	0.025	$	0.06	$	0.05

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

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THE NATIONAL SECURITY GROUP, INC.

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

(In thousands)



	Three months ended June 30,						Six months ended June 30,
	2014			2013			2014			2013

Net income	$	1,934		$	965		$	2,933		$	556

Other comprehensive income (loss), net of tax
Changes in:
Unrealized gains (losses) on securities, net of reclassification adjustment of $264 and $698 for 2014 and 2013, respectively	1,080			(2,482		)	2,153			(1,956		)
Unrealized gain (loss) on interest rate swap	(98		)	302			(174		)	354

Other comprehensive income (loss), net of tax	982			(2,180		)	1,979			(1,602		)

Comprehensive income (loss)	$	2,916		$	(1,215	)	$	4,912		$	(1,046	)

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

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THE NATIONAL SECURITY GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (UNAUDITED)

(In thousands)



	Total			Retained Earnings			Accumulated Other Comprehensive Income		Common Stock		Additional Paid-in Capital
Balance at December 31, 2013 (AUDITED)	$	33,472		$	24,894		$	936	$	2,495	$	5,147

Net income for the six months ended June 30, 2014	2,933			2,933

Other comprehensive income (net of tax)	1,979						1,979

Common stock issued	133								13		120

Cash dividends	(149		)	(149		)

Balance at June 30, 2014	$	38,368		$	27,678		$	2,915	$	2,508	$	5,267

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

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THE NATIONAL SECURITY GROUP, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (In thousands)



	Six months ended June 30,
	2014			2013
Cash Flows from Operating Activities
Net income	$	2,933		$	556
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation expense and amortization/accretion, net	262			398
Increase (decrease) in cash surrender value of company owned life insurance	(138		)	148
Net realized gains on investments	(400		)	(1,057		)
Deferred income taxes	26			(642		)
Amortization of deferred policy acquisition costs	1,771			1,865
Changes in assets and liabilities:
Change in accrued investment income	15			(24		)
Change in reinsurance recoverable	712			8
Policy acquisition costs deferred	(1,955		)	(1,812		)
Change in accrued income taxes	58			120
Change in net policy liabilities and claims	2,459			(1,614		)
Change in other assets/liabilities, net	(1,459		)	(587		)
Other, net	13			233
Net cash provided by (used in) operating activities	4,297			(2,408		)
Cash Flows from Investing Activities
Purchase of:
Available-for-sale securities	(8,619		)	(9,619		)
Property and equipment	(123		)	(67		)
Proceeds from sale or maturities of:
Held-to-maturity securities	83			364
Available-for-sale securities	5,865			8,319
Real estate held for investment	—			207
Property and equipment	219			6
Other invested assets, net	8			3
Net cash used in investing activities	(2,567		)	(787		)
Cash Flows from Financing Activities
Change in other policyholder funds	36			5
Change in long-term debt	275			300
Change in short-term notes payable	(700		)	75
Dividends paid	(149		)	(123		)
Net cash (used in) provided by financing activities	(538		)	257
Net change in cash and cash equivalents	1,192			(2,938		)
Cash and cash equivalents, beginning of year	4,987			6,779
Cash and cash equivalents, end of year	$	6,179		$	3,841

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

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

NOTE 1 – SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation and Basis of Presentation

The accompanying consolidated financial statements include the accounts of The National Security Group, Inc. (the Company) and its wholly-owned subsidiaries: National Security Insurance Company (NSIC), National Security Fire and Casualty Company (NSFC) and NATSCO, Inc. (NATSCO). NSFC includes a wholly-owned subsidiary, Omega One Insurance Company (Omega). The accompanying condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). In the opinion of management, all adjustments, consisting of normal and recurring items, necessary for the fair presentation of the consolidated financial statements have been included. All significant intercompany transactions and accounts have been eliminated. The financial information presented herein should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2013, which includes information and disclosures not presented herein.

Use of Estimates

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

Earnings Per Share

Earnings per share of common stock is based on the weighted average number of shares outstanding during each year. The adjusted weighted average shares outstanding were 2,495,770 in 2014 and 2,467,062 in 2013.

Reclassifications

Certain 2013 amounts have been reclassified from the prior year consolidated financial statements to conform to the 2014 presentation.

Concentration of Credit Risk

The Company maintains cash balances which are generally held in non-interest bearing demand deposit accounts. Through December 31, 2012, these balances were insured by the FDIC with no balance limits. On January 1, 2013, $250,000 per entity account balance limits were reinstated. At June 30, 2014, the net amount exceeding FDIC insured limits was $3,769,000 at one financial institution. The Company has not experienced any losses in such accounts. Management of the Company reviews financial information of the financial institution on a quarterly basis and believes the Company is not exposed to any significant credit risk on cash and cash equivalents.

Policy receivables are reported at unpaid balances. Policy receivables are generally offset by associated unearned premium liabilities and are not subject to significant credit risk. Receivables from agents, less provision for credit losses, are composed of balances due from independent agents. At June 30, 2014, the single largest balance due from one agent totaled $1,407,000.

Reinsurance contracts do not relieve the Company of its obligations to policyholders. A failure of a reinsurer to meet their obligation could result in losses to the insurance subsidiaries. Allowances for losses are established if amounts are believed to be uncollectible. At June 30, 2014 and 2013, no amounts were deemed uncollectible. The Company, at least annually, evaluates the financial condition of all reinsurers and evaluates any potential concentrations of credit risk. At June 30, 2014, management does not believe the Company is exposed to any significant credit risk related to its reinsurance program.

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

Recently Adopted Accounting Standards

Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists

In July 2013, the FASB issued guidance on the financial statement presentation of an unrecognized tax benefit when a net operating loss ("NOL") carryforward, a similar tax loss, or a tax credit carryforward exists. This guidance applies to all entities with unrecognized tax benefits that also have tax loss or tax credit carryforwards in the same tax jurisdiction as of the reporting date. This guidance is effective for fiscal years beginning after December 15, 2013. The Company adopted this standard on January 1, 2014. This guidance did not have a material effect on results of operations or financial position.

Revenue from Contracts with Customers

In May 2014, the FASB issued guidance on a comprehensive new revenue recognition standard. This standard will not impact accounting for insurance contracts, leases, financial instruments and guarantees. For those contracts that are impacted by the new guidance, the guidance will require an entity to recognize revenue upon the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled to, in exchange for those goods or services. The guidance requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to obtain or fulfill a contract. This guidance is effective retrospectively for fiscal years beginning after December 15, 2016 and interim periods within those years. Early adoption of this standard is not permitted. The Company is currently evaluating the impact of this guidance on its consolidated financial statement.

NOTE 2 – VARIABLE INTEREST ENTITIES

The Company holds a passive interest in a limited partnership that is considered to be a Variable Interest Entity (VIE) under the provisions of ASC 810 Consolidation. The Company is not the primary beneficiary of the entity and is not required to consolidate under ASC 810. The entity is a private placement investment fund formed for the purpose of investing in private equity investments. The Company owns less than 1% of the limited partnership. The carrying value of the investment totals $325,000 and is included as a component of Other Invested Assets in the accompanying consolidated balance sheets.

In December 2005, the Company formed National Security Capital Trust I, a statutory trust created under the Delaware Statutory Trust Act, for the sole purpose of issuing, in private placement transactions, $9,000,000 of trust preferred securities (TPS) and using the proceeds thereof, together with the equity proceeds received from the Company in the initial formation of the Trust, to purchase $9,279,000 of variable rate subordinated debentures issued by the Company. The Company owns all voting securities of the Trust and the subordinated debentures are the sole assets of the Trust. The Trust will meet the obligations of the TPS with the interest and principal paid on the subordinated debentures. The Company received net proceeds from the TPS transactions, after commissions and other costs of issuance, of $9,005,000. The Company also holds all the voting securities issued by the Trust and such trusts are considered to be VIE's. The Trust is not consolidated because the Company is not the primary beneficiary of the trust. The Subordinated Debentures, disclosed in Note 7, are reported in the accompanying consolidated balance sheets as a component of long-term debt. The Company's equity investments in the Trust total $279,000 and are included in Other Assets in the accompanying consolidated balance sheets.

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

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

NOTE 3 – INVESTMENTS

The amortized cost and aggregate fair values of investments in available-for-sale securities as of June 30, 2014 are as follows (dollars in thousands):



Available-for-sale securities:	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
Corporate debt securities	$	37,728	$	2,315	$	127	$	39,916
Mortgage backed securities	10,146		169		194		10,121
Private label mortgage backed securities	1,626		60		1		1,685
Obligations of states and political subdivisions	15,410		820		60		16,170
U.S. Treasury securities and obligations of U.S. Government corporations and agencies	17,074		375		249		17,200
Total fixed maturities	81,984		3,739		631		85,092
Equity securities	2,420		2,688		220		4,888
Total	$	84,404	$	6,427	$	851	$	89,980

The amortized cost and aggregate fair values of investments in held-to-maturity securities as of June 30, 2014 are as follows (dollars in thousands):



Held-to-maturity securities:	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
Mortgage backed securities	$	648	$	51	$	—	$	699
U.S. Treasury securities and obligations of U.S. Government corporations and agencies	80		4		—		84
Total	$	728	$	55	$	—	$	783

The amortized cost and aggregate fair values of investments in available-for-sale securities as of December 31, 2013 are as follows (dollars in thousands):



Available-for-sale securities:	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
Corporate debt securities	$	35,831	$	1,698	$	713	$	36,816
Trust preferred securities	538		33		—		571
Mortgage backed securities	7,622		75		557		7,140
Private label mortgage backed securities	2,152		38		4		2,186
Obligations of states and political subdivisions	16,412		524		195		16,741
U.S. Treasury securities and obligations of U.S. Government corporations and agencies	16,519		169		708		15,980
Total fixed maturities	79,074		2,537		2,177		79,434
Equity securities	2,420		2,365		411		4,374
Total	$	81,494	$	4,902	$	2,588	$	83,808

The amortized cost and aggregate fair values of investments in held-to-maturity securities as of December 31, 2013 are as follows (dollars in thousands):



Held-to-maturity securities:	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
Mortgage backed securities	$	706	$	34	$	—	$	740
U.S. Treasury securities and obligations of U.S. Government corporations and agencies	106		7		—		113
Total	$	812	$	41	$	—	$	853

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

The amortized cost and aggregate fair value of debt securities at June 30, 2014, by contractual maturity, are presented in the following table (dollars in thousands). Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.



	(Dollars in Thousands)
	Amortized Cost		Fair Value
Available-for-sale securities:
Due in one year or less	$	1,379	$	1,421
Due after one year through five years	16,015		17,320
Due after five years through ten years	29,227		30,207
Due after ten years	35,363		36,144
Total	$	81,984	$	85,092

Held-to-maturity securities:
Due in one year or less	$	—	$	—
Due after one year through five years	201		212
Due after five years through ten years	154		167
Due after ten years	373		404
Total	$	728	$	783

A summary of securities available-for-sale with unrealized losses as of June 30, 2014, along with the related fair value, aggregated by the length of time that investments have been in a continuous unrealized loss position, is as follows (dollars in thousands):



	Less than 12 months				12 months or longer				Total
June 30, 2014	Fair Value		Gross Unrealized Losses		Fair Value		Gross Unrealized Losses		Fair Value		Gross Unrealized Losses		Total Securities in a Loss Position
Fixed maturities
Corporate debt securities	$	2,354	$	22	$	4,206	$	105	$	6,560	$	127	12
Mortgage backed securities	1,162		8		3,025		186		4,187		194		14
Private label mortgage backed securities	—		—		129		1		129		1		1
Obligations of state and political subdivisions	222		3		1,550		57		1,772		60		5
U.S. Treasury securities and obligations of U.S. Government corporations and agencies	2,106		45		4,262		204		6,368		249		12
Equity securities	—		—		1,066		220		1,066		220		1
	$	5,844	$	78	$	14,238	$	773	$	20,082	$	851	45

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

A summary of securities available-for-sale with unrealized losses as of December 31, 2013, along with the related fair value, aggregated by the length of time that investments have been in a continuous unrealized loss position, is as follows (dollars in thousands):



	Less than 12 months				12 months or longer				Total
December 31, 2013	Fair Value		Gross Unrealized Losses		Fair Value		Gross Unrealized Losses		Fair Value		Gross Unrealized Losses		Total Securities in a Loss Position
Fixed maturities
Corporate debt securities	$	10,589	$	600	$	1,548	$	113	$	12,137	$	713	26
Mortgage backed securities	3,215		427		1,796		130		5,011		557		18
Private label mortgage backed securities	472		4		—		—		472		4		3
Obligations of state and political subdivisions	3,545		165		325		30		3,870		195		11
U.S. Treasury securities and obligations of U.S. Government corporations and agencies	11,534		600		390		108		11,924		708		21
Equity securities	—		—		875		411		875		411		1
	$	29,355	$	1,796	$	4,934	$	792	$	34,289	$	2,588	80

There were no securities held-to-maturity with unrealized losses as of June 30, 2014 and December 31, 2013.

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

Management has evaluated each security in a significant unrealized loss position. The Company has no material exposure to sub-prime mortgage loans and less than 2.1% of the fixed income investment portfolio is rated below investment grade. In evaluating whether or not the equity loss positions were other-than-temporary impairments, Management evaluated financial information on each company and where available, reviewed analyst reports from at least two independent sources. Based on a review of the available financial information, the prospect for future earnings of each company and consideration of the Company’s intent and ability to hold the securities until market values recovered, it was determined that the securities in an accumulated loss position in the portfolio were temporary impairments.

For the six months ended June 30, 2014 and 2013, the Company realized no additional other-than-temporary impairments.

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

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



	Three months ended June 30,					Six months ended June 30,
	2014		2013			2014		2013
Fixed maturities	$	857	$	815		$	1,716	$	1,640
Equity securities	29		45			58		73
Mortgage loans on real estate	3		6			7		13
Investment real estate	1		2			3		3
Policy loans	28		26			55		50
Company owned life insurance change in surrender value	108		(198		)	138		(148		)
Other, principally short-term investments	74		50			128		208
	1,100		746			2,105		1,839
Less: Investment expenses	70		57			127		105
Net investment income	$	1,030	$	689		$	1,978	$	1,734

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



	Three months ended June 30,					Six months ended June 30,
	2014		2013			2014		2013
Fixed maturities	$	159	$	104		$	249	$	127
Equity securities	—		928			—		928
Trading securities	—		—			—		—
Other, principally real estate	153		(2		)	151		2
Other-than-temporary impairments	—		—			—		—
Net realized investment gains	$	312	$	1,030		$	400	$	1,057

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



	June 30, 2014			December 31, 2013
Net change in unrealized appreciation on available-for-sale securities before deferred tax	$	3,262		$	(4,243	)
Deferred income tax	(1,109		)	1,442
Net change in unrealized appreciation on available-for-sale securities	$	2,153		$	(2,801	)

NOTE 4 – FAIR VALUE OF FINANCIAL ASSETS AND FINANCIAL LIABILITIES

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

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

Accounting standards define fair value as the price that would be received to sell an asset or would be paid to transfer a liability in an orderly transaction between market participants at the measurement date, and establishes a framework

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

to make the measurement of fair value more consistent and comparable. In determining fair value, we primarily use prices and other relevant information generated by market transactions involving identical or comparable assets.

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

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

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

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

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

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

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

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

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

Assets/Liabilities Measured at Fair Value on a Recurring Basis

Financial assets and liabilities measured at fair value on a recurring basis as of June 30, 2014 are summarized in the following table by the type of inputs applicable to the fair value measurements (unaudited) (in thousands):



	Fair Value Measurements at Reporting Date Using
Description	Total		Level 1		Level 2		Level 3
Financial Assets
Fixed maturities available-for-sale
Corporate debt securities	$	39,916	$	—	$	39,916	$	—
Trust preferred securities	—		—		—		—
Mortgage backed securities	10,121		—		10,121		—
Private label mortgage backed securities	1,685		—		1,685		—
Obligations of states and political subdivisions	16,170		—		16,170		—
U.S. Treasury securities and obligations of U.S. Government corporations and agencies	17,200		17,200		—		—
Trading securities	19		19		—		—
Equity securities available-for-sale	4,888		3,821		—		1,067
Total Financial Assets	$	89,999	$	21,040	$	67,892	$	1,067
Financial Liabilities
Interest rate swap	$	1,161	$	—	$	—	$	1,161
Total Financial Liabilities	$	1,161	$	—	$	—	$	1,161

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

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

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

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

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

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

As of June 30, 2014, Level 3 fair value measurements of assets include $1,067,000 of equity securities in a local community bank whose value is based on an evaluation of the financial statements of the entity. The Company does not develop the unobservable inputs used in measuring fair value.

As of June 30, 2014, Level 3 fair value measurements of liabilities include $1,161,000 net fair value of various interest rate swap agreements whose value is based on analysis provided by a third party broker who utilizes financial modeling

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

tools and assumptions on interest and other factors. The Company does not develop the unobservable inputs used in measuring fair value. Additional information regarding the interest rate swap agreements is provided in Note 7.

The table below presents a reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the six months ended June 30, 2014 (in thousands):



For the six months ended June 30, 2014	Equity Securities Available-for-Sale		Interest Rate Swap
Beginning balance	$	875	$	(897	)
Total gains or losses (realized and unrealized):
Included in earnings	—		—
Included in other comprehensive income	192		(264		)
Purchases:	—		—
Sales:	—		—
Issuances:	—		—
Settlements:	—		—
Transfers in/(out) of Level 3	—		—
Ending balance	$	1,067	$	(1,161	)
The amount of total gains or losses for the period included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held as of June 30, 2014:	$	—	$	—

For the six months ended June 30, 2014, there were no assets or liabilities measured at fair values on a nonrecurring basis.

Financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2013 are summarized in the following table by the type of inputs applicable to the fair value measurements (in thousands):



	Fair Value Measurements at Reporting Date Using
Description	Total		Level 1		Level 2		Level 3
Financial Assets
Fixed maturities available-for-sale
Corporate debt securities	$	36,816	$	—	$	36,816	$	—
Trust preferred securities	571		—		571		—
Mortgage backed securities	7,140		—		7,140		—
Private label mortgage backed securities	2,186		—		2,186		—
Obligations of states and political subdivisions	16,741		—		16,741		—
U.S. Treasury securities and obligations of U.S. Government corporations and agencies	15,980		15,980		—		—
Trading securities	19		19		—		—
Equity securities available-for-sale	4,374		3,499		—		875
Total Financial Assets	$	83,827	$	19,498	$	63,454	$	875
Financial Liabilities
Interest rate swap	$	897	$	—	$	—	$	897
Total Financial Liabilities	$	897	$	—	$	—	$	897

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

The table below presents a reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the year ended December 31, 2013 (in thousands):



For the year ended December 31, 2013	Equity Securities Available-for-Sale		Interest Rate Swap
Beginning balance	$	829	$	(1,521	)
Total gains or losses (realized and unrealized):
Included in earnings	—		—
Included in other comprehensive income	46		624
Purchases:	—		—
Sales:	—		—
Issuances:	—		—
Settlements:	—		—
Transfers in/(out) of Level 3	—		—
Ending balance	$	875	$	(897	)
The amount of total gains or losses for the period included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held as of December 31, 2013:	$	—	$	—

For the year ended December 31, 2013, there were no assets or liabilities measured at fair values on a nonrecurring basis.

The Company is exposed to certain risks in the normal course of its business operations. The primary risk that is managed through the use of derivatives is interest rate risk on floating rate borrowings. This risk is managed through the use of interest rate swap agreements which are designated as cash flow hedges. For cash flow hedges, the effective portion of the gain or loss on the interest rate swap is included as a component of other comprehensive income and reclassified into earnings in the same period during which the hedged transaction is recognized in earnings. The Company does not hold or issue derivatives that are not designated as hedging instruments. See Note 7 for additional information about the interest rate swap agreements.

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

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

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

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

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

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

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

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

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

The carrying amount and estimate fair value of the Company’s financial instruments as of June 30, 2014 and December 31, 2013 are as follows (in thousands):



	June 30, 2014				December 31, 2013
	Carrying Value		Estimated Fair Value		Carrying Value		Estimated Fair Value
Assets and related instruments
Mortgage loans	$	229	$	229	$	333	$	333
Policy loans	1,480		1,480		1,443		1,443
Company owned life insurance	5,996		5,996		5,858		5,858
Other invested assets	3,478		3,478		3,559		3,559

Liabilities and related instruments
Other policyholder funds	1,483		1,483		1,447		1,447
Short-term notes payable and current portion of long-term debt	1,166		1,166		1,866		1,866
Long-term debt	21,164		21,164		20,889		20,889

NOTE 5 – PROPERTY AND EQUIPMENT

Major categories of property and equipment are summarized as follows (dollars in thousands):



	June 30, 2014		December 31, 2013

Building and improvements	$	3,207	$	3,185
Electronic data processing equipment	1,869		1,822
Furniture and fixtures	831		874
	5,907		5,881
Less accumulated depreciation	3,916		3,804
Property and equipment, net	$	1,991	$	2,077

Depreciation expense for the six months ended June 30, 2014 was $170,000 ($386,000 for the year ended December 31, 2013).

NOTE 6 – INCOME TAXES

The Company recognizes tax-related interest and penalties as a component of tax expense. The Company files income tax returns in the U.S. federal jurisdiction and various states. The Company is not subject to examinations by authorities related to its U.S. federal or state income tax filings for years prior to 2010. Tax returns have been filed through the year 2012. Extensions have been filed for 2013.

Net deferred tax liabilities are determined based on the estimated future tax effects of differences between the financial statement and tax basis of assets and liabilities given the provisions of the enacted tax laws. Management believes that, based on its historical pattern of taxable income, the Company will produce sufficient income in the future to realize its deferred tax assets. The Company recognized net deferred tax asset positions of $3,609,000 at June 30, 2014 and $4,654,000 at December 31, 2013.

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

The tax effect of significant differences representing deferred tax assets and liabilities are as follows (dollars in thousands):



	As of June 30, 2014			As of December 31, 2013
General expenses	$	1,359		$	1,326
Unearned premiums	2,074			1,855
Claims liabilities	887			700
Litigation settlement	3,173			3,173
AMT credit	335			335
NOL carryforward	436			849
Unrealized loss on interest rate swaps	395			305
Deferred tax assets	8,659			8,543

Depreciation	(108		)	(119		)
Deferred policy acquisition costs	(3,047		)	(2,984		)
Unrealized gains on securities available-for-sale	(1,895		)	(786		)
Deferred tax liabilities	(5,050		)	(3,889		)
Net deferred tax asset	$	3,609		$	4,654

The appropriate income tax effects of changes in temporary differences are as follows (dollars in thousands):



	Six months ended June 30,
	2014			2013
Deferred policy acquisition costs	$	63		$	(19	)
Trading securities	—			(1		)
Unearned premiums	(219		)	(164		)
General expenses	(33		)	(82		)
Depreciation	(11		)	(17		)
Claim liabilities	(187		)	(197		)
NOL carryforward	413			(162		)
Deferred income tax expense (benefit)	$	26		$	(642	)

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



	Six months ended June 30,
	2014		2013
Federal income tax rate applied to pre-tax income/loss	34.0	%	34.0	%
Dividends received deduction and tax-exempt interest	(2.0	)%	(48.2	)%
Company owned life insurance	(19.1	)%	37.7	%
Small life deduction	(8.9	)%	(197.3	)%
Life reserve tax adjustment	—	%	(147.4	)%
Other, net	2.2	%	6.2	%
Effective federal income tax rate	6.2	%	(315.0	)%

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

At June 30, 2014, the Company has approximately $1,283,000 of net operating loss carryforwards available ($436,000 tax benefit) to be applied to future periods. These carryforwards expire in 2031 and 2032.

NOTE 7 – NOTES PAYABLE AND LONG-TERM DEBT

Short-term debt and current portion of long-term debt consisted of the following as of June 30, 2014 and December 31, 2013 (dollars in thousands):



	2014		2013
Line of credit with variable interest rate equal to the Wall Street Journal (WSJ) prime rate, subject to a 5.0% floor; maturity February 2014. Interest payments due quarterly. Unsecured.	$	—	$	700
Current portion of installment note payable due November 2014 with variable interest rate equal to the WSJ prime rate plus 1%; Unsecured	1,166		1,166
	$	1,166	$	1,866

Long-term debt consisted of the following as of June 30, 2014 and December 31, 2013 (dollars in thousands):



	2014		2013
Line of credit with variable interest rate equal to the WSJ prime rate, subject to a 5.0% floor; maturity February 2016. Interest payments due quarterly. Unsecured.	$	275	$	—

Line of credit with variable interest rate equal to the WSJ prime rate, subject to a 4.5% floor; maturity September 2017. Interest payments due monthly. Secured.	350		350

Long term portion of installment note with variable interest rate equal to the WSJ prime rate plus 1% and adjustable each November; maturity November 2021. Interest payable annually with principal payable in equal annual installments. Next principal installment on long term portion due November 2015. Unsecured.	8,167		8,167

Subordinated debentures issued on December 15, 2005 with fixed interest rate of 8.83% each distribution period thereafter until December 15, 2015 when the coupon rate shall equal the 3-Month LIBOR plus 3.75% applied to the outstanding principal; maturity December 2035. Interest payments due quarterly. All may be redeemed at any time following the tenth anniversary of issuance. Unsecured.	9,279		9,279

Subordinated debentures issued on June 21, 2007 with a floating interest rate equal to the 3-Month LIBOR plus 3.40% applied to the outstanding principal; maturity June 15, 2037. Interest payments due quarterly. All may be redeemed at any time following the fifth anniversary of issuance. Unsecured.	3,093		3,093
	$	21,164	$	20,889

On May 26, 2010, the Company entered into a forward swap with a notional amount of $9,000,000 effective December 15, 2015, which will hedge against changes in cash flows following the termination of the fixed rate period. Quarterly, commencing March 16, 2016 under the terms of the forward swap, the Company will pay interest at a fixed rate of 8.49% until March 15, 2020.

The swaps entered into in 2009 and 2010 have fair values of $289,000 (liability) and $872,000 (liability), respectively, for a total liability of $1,161,000 at June 30, 2014 ($897,000 at December 31, 2013). The swap liability is reported as a component of other liabilities on the consolidated balance sheets. A net valuation loss of $174,000 (net of tax) is included in accumulated other comprehensive income related to the swap agreements for the current period. A net valuation gain of $412,000 (net of tax) was included in accumulated other comprehensive income related to the swap at December 31, 2013.

We use dollar offset at the hedge's inception and for each reporting period thereafter to assess whether the derivative used in a hedging transaction is expected to be, and has been, effective in offsetting changes in the fair value of the

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

hedged item. Since inception, no portion of the hedged item has been deemed ineffective. For all hedges, we discontinue hedge accounting if it is determined that a derivative is not expected to be, or has ceased to be, effective as a hedge.

The Company’s interest rate swaps include provisions requiring the Company to post collateral when the derivative is in a net liability position. At June 30, 2014, the Company has securities on deposit with fair market values of $1,469,000 (all of which is posted as collateral). At December 31, 2013, the Company had securities on deposit with fair market values of $1,422,000 (all of which is posted as collateral). See Note 4 for additional information about the interest rate swaps.

NOTE 8 – REINSURANCE

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

In the normal course of business, NSFC seeks to reduce the loss that may arise from catastrophes or other individually significant large loss events that cause unfavorable underwriting results by re-insuring certain levels of risk in various areas of exposure with reinsurance companies. NSFC maintains a catastrophe reinsurance agreement to cover losses from catastrophic events, primarily hurricanes.

Under the catastrophe reinsurance program, the Company retains the first $4,000,000 in losses from each catastrophe event. Catastrophe reinsurance coverage is maintained in four layers as follows:



Layer	Reinsurers' Limits of Liability
First Layer	100% of $6,000,000 in excess of $4,000,000
Second Layer	100% of $7,500,000 in excess of $10,000,000
Third Layer	100% of $25,000,000 in excess of $17,500,000
Fourth Layer	100% of $30,000,000 in excess of $42,500,000

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

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

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

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

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

At June 30, 2014, the largest reinsurance recoverable of a single reinsurer was $22,000 ($214,000 at December 31, 2013). Amounts reported as ceded incurred losses in both 2014 and 2013 were related to the development of losses from prior year catastrophes.

NOTE 9 – EMPLOYEE BENEFIT PLANS

The Company and its subsidiaries have an established retirement savings plan (401K Plan). All full-time employees are eligible to participate, and all employer contributions are fully vested for employees who have completed 1,000 hours of service in the year of contribution. Company matching contributions for the six months ended June 30, 2014 and 2013 amounted to $104,000 and $97,000, respectively. The Company contributes dollar-for-dollar matching contributions up to 5% of compensation subject to government limitations.

In January 2006, the Company established a non-qualified plan under which directors are allowed to defer all or a portion of directors' fees into various investment options.

The supplemental executive retirement plan (SERP) became effective March 1, 2008 and covers named executive officers with the Company contributing 15% of executive compensation to the plan. Contributions to the plan are fully vested upon the earlier of death, disability, change in control, or ten years of participation in the plan. Costs for amounts credited of the non-qualified deferred compensation plans for the six months ended June 30, 2014 and 2013 amounted to approximately $102,000 and $113,000, respectively.

The Company and its subsidiaries established an Employee Stock Ownership Plan (ESOP) in January 2010, to enable its eligible employees to acquire a proprietary interest in the Company's common stock and to provide retirement and other benefits to such employees. There were $100,000 in costs incurred during the first six months of 2014 and $50,000 costs incurred for the first six months of 2013 related to the ESOP. All contributions were made in cash for purchase of Company shares in the open market. The Company has not allocated shares directly to the plan and the plan has no debt.

NOTE 10 – SHAREHOLDERS' EQUITY

During the six months ended June 30, 2014, and year ended December 31, 2013, changes in shareholders' equity consisted of net income of $2,933,000 and $5,658,000, respectively; dividends paid of $149,000 in 2014 and $248,000 in 2013; changes in accumulated other comprehensive income, net of applicable taxes, of $1,979,000 in 2014 and other comprehensive loss, net of applicable taxes, of $2,389,000 in 2013. Other comprehensive loss consists of accumulated unrealized gains and losses on securities and unrealized gains and losses on interest rate swaps.

The table below provides information regarding the Company's preferred and common stock as of June 30, 2014 and December 31, 2013:



	Authorized	Issued	Outstanding	Authorized	Issued	Outstanding
Preferred Stock, $1 par value	500,000	—	—	500,000	—	—
Class A Common Stock, $1 par value	2,000,000	—	—	2,000,000	—	—
Common Stock, $1 par value	3,000,000	2,507,452	2,507,452	3,000,000	2,494,480	2,494,480

On June 13, 2014, 12,972 shares of common stock were issued to directors as compensation under the 2009 Equity Incentive Plan previously approved by shareholders.

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

NOTE 11 – ACCUMULATED OTHER COMPREHENSIVE INCOME

Accumulated other comprehensive income (loss) ("AOCI") includes certain items that are reported directly within a separate component of shareholders' equity. The following table presents changes in AOCI balances (dollars in thousands):



	Six Months Ended June 30,
	2014			2013
Gains and Losses on Cash Flow Hedges
Balance at beginning of period	$	(591	)	$	(1,003	)
Other comprehensive income (loss) for period:
Other comprehensive income (loss) before reclassifications	(174		)	354
Amounts reclassified from accumulated other comprehensive income	—			—
Net current period other comprehensive income (loss)	(174		)	354
Balance at end of period	$	(765	)	$	(649	)

Unrealized Gains and Losses on Available-for-Sale Securities
Balance at beginning of period	$	1,527		$	4,328
Other comprehensive income (loss) for period:
Other comprehensive income before reclassifications	2,417			(1,258		)
Amounts reclassified from accumulated other comprehensive income	(264		)	(698		)
Net current period other comprehensive income	2,153			(1,956		)
Balance at end of period	$	3,680		$	2,372
Total Accumulated Other Comprehensive Income (loss) at end of period	$	2,915		$	1,723

The following table presents the amounts reclassified out of AOCI for the six months ended June 30, 2014 (dollars in thousands):



Details about Accumulated Other Comprehensive Income Components	Amounts Reclassified from Accumulated Other Comprehensive Income			Affected Line Item in the Statement Where Net Income is Presented
Unrealized Gains and Losses on Available-for-Sale Securities	$	400		Net realized investment gains
	400			Total before tax

	(136		)	Tax (expense) or benefit
	$	264		Net of Tax

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

The following table presents the amounts reclassified out of AOCI for the six months ended June 30, 2013 (dollars in thousands):



Details about Accumulated Other Comprehensive Income Components	Amounts Reclassified from Accumulated Other Comprehensive Income			Affected Line Item in the Statement Where Net Income is Presented
Unrealized Gains and Losses on Available-for-Sale Securities	$	1,057		Net realized investment gains
	1,057			Total before tax

	(359		)	Tax (expense) or benefit
	$	698		Net of Tax

NOTE 12 – SEGMENTS

The Company’s property and casualty insurance operations comprise one business segment. The property and casualty insurance segment primarily underwrites home insurance coverage with primary lines of business consisting of: dwelling fire and extended coverage, homeowners (including mobile homeowners) and other liability. The Company has ceased writing ocean marine, private passenger auto liability, commercial auto liability and auto physical damage coverages over the past two years with no policies remaining in-force at December 31, 2013 in the lines of business.

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

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

Total assets by industry segment at June 30, 2014 and at December 31, 2013 are summarized below (dollars in thousands):



	Total		P&C Insurance Operations		Life Insurance Operations		Non-Insurance Operations
June 30, 2014
	$	143,267	$	79,722	$	56,420	$	7,125
December 31, 2013
	$	133,980	$	71,003	$	53,831	$	9,146

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

Premium revenues and operating income by business segment for the three and six months ended June 30, 2014 and 2013 are summarized below (dollars in thousands):



Three months ended June 30, 2014	Total		P&C Insurance Operations		Life Insurance Operations			Non-Insurance Operations
REVENUE
Net premiums earned	$	14,100	$	12,467	$	1,633		$	—
Net investment income	1,030		508		503			19
Net realized investment gains	312		1		310			1
Other income	1,713		1,713		—			—
	17,155		14,689		2,446			20
BENEFITS, LOSSES AND EXPENSES
Policyholder benefits paid	9,155		7,566		1,589			—
Amortization of deferred policy acquisition costs	873		641		232			—
Commissions	1,967		1,890		77			—
General and administrative expenses	2,413		1,532		598			283
Taxes, licenses and fees	521		457		64			—
Interest expense	382		—		14			368
	15,311		12,086		2,574			651
Income (Loss) Before Income Taxes	$	1,844	$	2,603	$	(128	)	$	(631	)



Three months ended June 30, 2013	Total		P&C Insurance Operations		Life Insurance Operations			Non-Insurance Operations
REVENUE
Net premiums earned	$	13,038	$	11,376	$	1,662		$	—
Net investment income	689		219		451			19
Net realized investment gains	1,030		1,028		2			—
Other income	145		145		—			—
	14,902		12,768		2,115			19
BENEFITS, LOSSES AND EXPENSES
Policyholder benefits paid	8,260		7,076		1,184			—
Amortization of deferred policy acquisition costs	923		638		285			—
Commissions	1,486		1,396		90			—
General and administrative expenses	2,162		1,363		510			289
Taxes, licenses and fees	474		423		51			—
Interest expense	435		—		17			418
	13,740		10,896		2,137			707
Income (Loss) Before Income Taxes	$	1,162	$	1,872	$	(22	)	$	(688	)

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)



Six months ended June 30, 2014	Total		P&C Insurance Operations		Life Insurance Operations			Non-Insurance Operations
REVENUE
Net premiums earned	$	27,924	$	24,640	$	3,284		$	—
Net investment income	1,978		963		977			38
Net realized investment gains	400		49		350			1
Other income	1,867		1,866		1			—
	32,169		27,518		4,612			39
BENEFITS AND EXPENSES
Policyholder benefits paid	17,019		14,230		2,789			—
Amortization of deferred policy acquisition costs	1,771		1,282		489			—
Commissions	3,994		3,835		159			—
General and administrative expenses	4,439		2,989		1,058			392
Taxes, licenses and fees	1,051		921		130			—
Interest expense	768		—		31			737
	29,042		23,257		4,656			1,129
Income (Loss) Before Income Taxes	$	3,127	$	4,261	$	(44	)	$	(1,090	)



Six months ended June 30, 2013	Total		P&C Insurance Operations		Life Insurance Operations		Non-Insurance Operations
REVENUE
Net premiums earned	$	25,972	$	22,564	$	3,408	$	—
Net investment income	1,734		696		1,000		38
Net realized investment gains	1,057		1,030		27		—
Other income	317		315		2		—
	29,080		24,605		4,437		38
BENEFITS AND EXPENSES
Policyholder benefits paid	17,811		15,629		2,182		—
Amortization of deferred policy acquisition costs	1,865		1,299		566		—
Commissions	3,468		3,282		186		—
General and administrative expenses	3,965		2,608		912		445
Taxes, licenses and fees	960		835		125		—
Interest expense	877		—		38		839
	28,946		23,653		4,009		1,284
Income (Loss) Before Income Taxes	$	134	$	952	$	428	$	(1,246	)

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

The following table presents the Company’s gross and net premiums written for the property and casualty segment and the life and accident and health segment for the three and six months ended June 30, 2014 and 2013, respectively:



	Three months ended June 30,						Six months ended June 30,
	2014			2013			2014			2013
Life, accident and health operations premiums written:
Traditional life insurance	$	1,137		$	1,184		$	2,316		$	2,402
Accident and health insurance	431			437			875			881
Gross life, accident and health	1,568			1,621			3,191			3,283
Reinsurance premium ceded	(12		)	(11		)	(35		)	(30		)
Net life, accident and health premiums written	$	1,556		$	1,610		$	3,156		$	3,253

Property and Casualty operations premiums written:
Dwelling fire & extended coverage	$	9,219		$	8,406		$	17,548		$	15,965
Homeowners (Including mobile homeowners)	6,879			6,756			12,628			12,177
Ocean marine	—			(17		)	—			75
Other liability	521			474			990			882
Gross property and casualty	16,619			15,619			31,166			29,099
Reinsurance premium ceded	(1,802		)	(2,188		)	(3,557		)	(4,320		)
Net property and casualty written	$	14,817		$	13,431		$	27,609		$	24,779

Gross premiums written	$	18,187		$	17,240		$	34,357		$	32,382
Reinsurance premium ceded	(1,814		)	(2,199		)	(3,592		)	(4,350		)
Net premiums written	$	16,373		$	15,041		$	30,765		$	28,032

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

The following table presents the Company’s gross and net premiums earned for the property and casualty segment and the life and accident and health segment for the three and six months ended June 30, 2014 and 2013, respectively:



	Three months ended June 30,						Six months ended June 30,
	2014			2013			2014			2013
Life, accident and health operations premiums earned:
Traditional life insurance	$	1,214		$	1,240		$	2,457		$	2,556
Accident and health insurance	431			433			862			882
Gross life, accident and health	1,645			1,673			3,319			3,438
Reinsurance premium ceded	(12		)	(11		)	(35		)	(30		)
Net life, accident and health premiums earned	$	1,633		$	1,662		$	3,284		$	3,408

Property and Casualty operations premiums earned:
Dwelling fire & extended coverage	$	7,910		$	7,256		$	15,580		$	14,274
Homeowners (Including mobile homeowners)	5,916			5,652			11,747			11,333
Ocean marine	—			269			—			524
Other liability	443			391			870			764
Gross property and casualty	14,269			13,568			28,197			26,895
Reinsurance premium ceded	(1,802		)	(2,192		)	(3,557		)	(4,331		)
Net property and casualty earned	$	12,467		$	11,376		$	24,640		$	22,564

Gross premiums earned	$	15,914		$	15,241		$	31,516		$	30,333
Reinsurance premium ceded	(1,814		)	(2,203		)	(3,592		)	(4,361		)
Net premiums earned	$	14,100		$	13,038		$	27,924		$	25,972

NOTE 13 – CONTINGENCIES

The Company and its subsidiaries continue to be named individually as parties to litigation related to the conduct of their insurance operations. These suits involve alleged breaches of contracts, torts, including bad faith and fraud claims based on alleged wrongful or fraudulent acts of the Company's subsidiaries, and other miscellaneous causes of action.

The Company's property & casualty subsidiaries are defending a limited number of matters filed in the aftermath of Gustav and Ike in Texas. These actions include individual lawsuits with allegations of underpayment of hurricane-related claims.

The various suits seek a variety of remedies, including actual and/or punitive damages in unspecified amounts and/or declaratory relief. The Company has reserves set up on litigated claims and the reserves are included in benefit and loss reserves.

NOTE 14 – SUPPLEMENTAL CASH FLOW INFORMATION

Cash paid for interest during the six months ended June 30, 2014 was $568,000 ($649,000 in 2013). Cash paid for income taxes during the six months ended June 30, 2014 was $111,000 ($100,000 in 2013).

During the six months ended June 30, 2014, non-cash changes in equity included $13,000 in common stock issued to Directors in lieu of cash compensation along with a corresponding $120,000 increase in additional paid in capital.

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

NOTE 15 – SUBSEQUENT EVENTS

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

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REVIEW REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders

The National Security Group, Inc.

We have reviewed the accompanying condensed consolidated balance sheet of The National Security Group, Inc. as of June 30, 2014, and the related condensed consolidated statements of income and comprehensive income (loss) for the three-months and six-months ended June 30, 2014 and 2013, the condensed consolidated statement of shareholders' equity for the six-months ended June 30, 2014 and the condensed consolidated statements of cash flows for the six-months ended June 30, 2014 and 2013. These condensed consolidated financial statements are the responsibility of the Company's management.

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

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

We have previously audited, in accordance with auditing standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of The National Security Group, Inc. as of December 31, 2013, and the related consolidated statements of income (loss), comprehensive income (loss), shareholders' equity, and cash flows for the year then ended (not presented herein); and in our report dated March 21, 2014, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 2013, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.



/s/ Warren Averett, LLC

Birmingham, Alabama
August 13, 2014

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Item 2. 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. We are a “smaller reporting company” under Securities and Exchange Commission (SEC) regulations and therefore qualify for the scaled disclosure of smaller reporting companies. In general, the same information is required to be disclosed in the management discussion and analysis by smaller reporting companies except that the discussion need only cover the latest two year period and disclosures relating to contractual obligations are not required. In accordance with the scaled disclosure requirements, this discussion covers the three-month and six-month periods ended June 30, 2014 and 2013.

The National Security Group, Inc. is made up of two segments: the Life segment and the P&C segment. 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. 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 discussion and analysis should be read in conjunction with the unaudited consolidated financial statements and related notes thereto included in Part I, Item 1 of this report and with our audited consolidated financial statements and related notes thereto contained in our Annual Report on Form 10-K for the year ended December 31, 2013.

Information in this discussion is presented in whole dollars rounded to the nearest thousand. Tabular amounts are presented in thousands.

The National Security Group operates in the property and casualty and life, accident and supplemental health insurance businesses and markets products primarily through independent agents. The Company operates in ten states with 50.2% of total premium revenue generated in the states of Alabama and Mississippi. Property and casualty insurance is the most significant segment, accounting for 89.5% of gross insurance premium revenue in the first six months of 2014. Revenue generated from the life segment accounted for 10.5% of gross insurance premium revenue in the first six months of 2014.

National Security Insurance Company (NSIC) is a life, accident and health insurance company founded in 1947. All references to NSIC in the remainder of this management discussion and analysis will refer to the combined life, accident and health insurance operations and will compose the life segment of the Company. NSIC is licensed to underwrite life and accident and health insurance in Alabama, Florida, Georgia, Mississippi, South Carolina, Tennessee and Texas.

The property and casualty segment consists of the consolidated operations of two subsidiaries, National Security Fire and Casualty Company and its wholly owned subsidiary, Omega One Insurance Company. There is no material differentiation between the products underwritten by NSFC and Omega as both underwrite primarily dwelling personal lines coverage. The Property and Casualty segment has premium in-force in the states of Alabama, Arkansas, Georgia, Louisiana, Mississippi, Oklahoma, South Carolina, and Tennessee.

All of the insurance subsidiaries are Alabama domiciled insurance companies; therefore, the Alabama Department of Insurance is the primary insurance regulator. However, each subsidiary is subject to regulation by the respective insurance regulators of each state in which it is licensed to transact business. Insurance rates charged by each of the insurance subsidiaries are typically reviewed and approved by each insurance department for the respective state in which the rates will apply.

All of our insurance companies have been assigned ratings by A.M. Best Co (Best). On November 20, 2013, Best affirmed the financial strength rating (FSR) of B++ (Good) and the issuer credit rating (ICR) of "bbb" of NSFC. Best maintained the negative outlook on both of NSFC's ratings. In addition, Best affirmed the FSR of B+(Good) and ICR of "bbb-" of Omega and NSIC. The outlook for all of these ratings is stable. Best also affirmed the ICR of "bb" of the parent holding company, NSEC, with a negative outlook.

The property and casualty subsidiaries have been assigned ratings by Demotech, Inc. On November 22, 2013, Demotech affirmed a Financial Stability Rating of A (Exceptional) for both NSFC and Omega.

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The two primary segments in which we report insurance operations are the personal lines property and casualty segment (NSFC) and the life, accident and health insurance segment (NSIC). Due to the small amount of earned premium revenue produced by Omega and the fact that Omega is a wholly owned subsidiary of NSFC underwriting similar lines of business, all references to NSFC in the remainder of this management discussion and analysis will include the insurance operations of both NSFC and Omega. Our income is principally derived from net underwriting profits and investment income. Net underwriting profit is principally derived from earned premiums received less claims paid, sales commissions to agents, costs of underwriting and insurance taxes and fees. Investment income includes interest and dividend income and gains and losses on investment holdings.

The property and casualty segment can be impacted by severe storm activity resulting in incurred losses and loss adjustment expenses (LAE) primarily from hurricane, tornado, wind and hail related damage. These storm systems or other natural disasters are classified as catastrophes (referred to as "cat events" or "catastrophe events" throughout the remainder of this document) by Property Claim Service (PCS) when these events cause $25 million or more in industry wide direct insured losses and affect a significant number of policyholders and insurers.

Summary of Consolidated Results of Operations

Financial results for the three months and six months ended June 30, 2014 and 2013 were as follows:



(dollars in thousands)	Three months ended June 30,						Six months ended June 30,
	2014			2013			2014			2013
REVENUES
Net premiums earned	$	14,100		$	13,038		$	27,924		$	25,972
Net investment income	1,030			689			1,978			1,734
Net realized investment gains	312			1,030			400			1,057
Other income	1,713			145			1,867			317
Total Revenues	17,155			14,902			32,169			29,080
BENEFITS, LOSSES AND EXPENSES
Policyholder benefits and settlement expenses	9,155			8,260			17,019			17,811
Amortization of deferred policy acquisition costs	873			923			1,771			1,865
Commissions	1,967			1,486			3,994			3,468
General and administrative expenses	2,413			2,162			4,439			3,965
Taxes, licenses and fees	521			474			1,051			960
Interest expense	382			435			768			877
Total Benefits, Losses and Expenses	15,311			13,740			29,042			28,946
Income (Loss) Before Income Taxes	1,844			1,162			3,127			134
INCOME TAX EXPENSE (BENEFIT)
Current	80			88			168			220
Deferred	(170		)	109			26			(642		)
	(90		)	197			194			(422		)
Net Income	$	1,934		$	965		$	2,933		$	556
INCOME PER COMMON SHARE	$	0.77		$	0.39		$	1.18		$	0.23

DIVIDENDS DECLARED PER SHARE	$	0.03		$	0.025		$	0.06		$	0.05
Reconciliation of Net Income to non-GAAP Measurement
Net income	$	1,934		$	965		$	2,933		$	556
Income tax expense (benefit)	(90		)	197			194			(422		)
Realized investment gains, net	(312		)	(1,030		)	(400		)	(1,057		)
Operating Income (Loss)	$	1,532		$	132		$	2,727		$	(923	)

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Three months ended June 30, 2014 compared to three months ended June 30, 2013:

For the three months ended June 30, 2014, the Company had net income of $1,934,000, $0.77 per share, compared to $965,000, $0.39 per share, for the same period last year. On a pretax basis, for the three months ended June 30, 2014, we had income of $1,844,000 compared to $1,162,000 for the three months ended June 30, 2013. Our pretax income for the three months ended June 30, 2014, consisted of income from operations of $1,532,000 and realized investment gains of $312,000. The pretax income for the three months ended June 30, 2013, consisted of income from operations of $132,000 and realized investment gains of $1,030,000.

The primary component of our $1,532,000 in income from operations for the three months ended June 30, 2014 was a non-recurring $1,621,000 net gain from company owned life insurance (reported as a component of Other Income in the preceding table). Income from operations for the second quarter was adversely impacted by an increase in policy holder benefit claims, particularly in our P&C segment.

Claims for the three months ended June 30, 2014 were $9,155,000 compared to $8,260,000 for the same period last year. The $895,000 increase during the second quarter, compared to last year, was primarily due an increase in catastrophe losses in our P&C segment. Catastrophe losses reported in the second quarter of 2014 were up $1,305,000 compared the second quarter of 2013.

Six months ended June 30, 2014 compared to six months ended June 30, 2013:

Net premium earned increased 7.5% in the first half of 2014 compared to the same period last year. A combination of increased direct premium revenue and a decrease in reinsurance cost (ceded premium) were the two primary factors contributing to the increase in net premium earned for the six months ended June 30, 2014. Increases in direct premium were driven by a combination of rate increases implemented in our core dwelling and homeowners programs along with a moderate increase in policy issuance. The decrease in reinsurance cost, reducing ceded premium, was due to an 18% reduction in our catastrophe reinsurance cost.

The Company ended the first half of 2014 with net income of $2,933,000, $1.18 per share, compared to net income of $556,000, $0.23 per share, for the same period last year. On a pretax basis, for the six months ended June 30, 2014, we had income of $3,127,000 compared to $134,000 for the six months ended June 30, 2013. Our pretax income for the six months ended June 30, 2014, consisted of income from operations of $2,727,000 and realized investment gains of $400,000. The pretax income for the six months ended June 30, 2013, consisted of a loss from operations of $923,000 and realized investment gains of $1,057,000.

The primary component of the $2,727,000 in income from operations for the six months ended June 30, 2014 was a non-recurring $1,621,000 net gain from company owned life insurance. In addition to the COLI gain, operating income was much improved in 2014 due to lower P&C segment claims activity in the first quarter of 2014.

Year to date claims were down $792,000 in 2014 compared to 2013. The primary reason for the year to date decrease in 2014 compared to 2013 was a reduction in claims related to both cat events and non-catastrophe wind losses in our P&C segment due to a lower frequency of claims in the first quarter of this year. Through June 30, 2014, the P&C segment had a $1,529,000 reduction in cat event losses compared to the same period last year. During 2014, the P&C segment was impacted by six cat events totaling $2,454,000 compared to nine cat events in 2013 totaling $3,983,000. In addition, non-catastrophe wind loses were down $250,000 in 2014 compared to 2013. Offsetting these decreases were a $618,000 increase in claims from fire related losses as well as $600,000 in adverse loss development from the settlement of a claim in a discontinued commercial insurance program.

Shareholders' equity as of June 30, 2014 was $38,368,000 up $4,896,000 from our December 31, 2013 Shareholders' equity of $33,472,000. Book value per share increased $1.88 over the six month period ended June 30, 2014 to $15.30 per share compared to $13.42 per share at December 31, 2013. The primary factors contributing to the increase in Shareholders' equity in the first six months of 2014 was net income of $2,933,000 and other comprehensive income of $1,979,000. The increase in other comprehensive income was primarily driven by the declining interest rate environment which increased the market value of our investments in fixed income securities.

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Three months ended June 30, 2014 compared to three months ended June 30, 2013:

Premium revenue:

The table below provides earned premium revenue by segment for the three months ended June 30, 2014

and 2013:



	Three months ended June 30,						Percent
	2014			2013			increase (decrease)
Life, accident and health operations premiums earned:
Traditional life insurance	$	1,214		$	1,240		(2.1	)%
Accident and health insurance	431			433			(0.5	)%
Gross life, accident and health	1,645			1,673			(1.7	)%
Reinsurance premium ceded	(12		)	(11		)	9.1	%
Net life, accident and health premiums earned	$	1,633		$	1,662		(1.7	)%

Property and Casualty operations premiums earned:
Dwelling fire & extended coverage	$	7,910		$	7,256		9.0	%
Homeowners (Including mobile homeowners)	5,916			5,652			4.7	%
Ocean marine	—			269			(100.0	)%
Other liability	443			391			13.3	%
Gross property and casualty	14,269			13,568			5.2	%
Reinsurance premium ceded	(1,802		)	(2,192		)	(17.8	)%
Net property and casualty premiums earned	$	12,467		$	11,376		9.6	%

Gross premiums earned	$	15,914		$	15,241		4.4	%
Reinsurance premium ceded	(1,814		)	(2,203		)	(17.7	)%
Net premiums earned	$	14,100		$	13,038		8.1	%

Consolidated net premium earned was up 8.1% for the quarter ended June 30, 2014, at $14,100,000 compared to $13,038,000 for the quarter ended June 30, 2013. The increase in net premium earned was due to a 9.6% increase in net premium in the P&C segment which was driven by increases in direct premium due to rate increases and a modest increase in production. A 17.8% reduction in catastrophe reinsurance cost also contributed to the increase in net earned premium in the P&C segment. The reduction in catastrophe reinsurance cost was due to a catastrophe reinsurance rate reduction in our 2014 calendar year renewal.

Investment income:

For the three months ended June 30, 2014, net investment income totaled $1,030,000 compared to $689,000 for the same period last year; an increase of $341,000. Investment income in second quarter 2013 was adversely impacted by an interest rate driven decline in value of our company owned life insurance cash value. This decline in cash value in 2013 was the primary component contributing to the difference in investment income.

Realized investment gains and losses:

For the three months ended June 30, 2014, the Company had realized capital gains totaling $312,000 compared to $1,030,000 for the same period last year. The $718,000 decline was primarily associated with a reduction in the sale of securities in our investment portfolio. The realization of capital gains in the investment portfolio is influenced by both market conditions and liquidity requirements and therefore can vary significantly from quarter to quarter and year to year. Other activities, such as tax planning strategies, may also lead to significant variation in realized capital gains from year to year.

Other income:

Other income was $1,713,000 for the three months ended June 30, 2014 compared to $145,000 for the same period last year; an increase of $1,568,000. The primary reason for the increase was net proceeds of $1,621,000 received on a policy covering a former manager of the Company under our company owned life insurance program. The remainder of other income consists primarily of fees related to the issuance of our property insurance policies as well as miscellaneous income.

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Policyholder benefits:

Policyholder claims were $9,155,000 for the three months ended June 30, 2014, compared to $8,260,000 for the same period last year; an increase of $895,000 or 10.8%. The $895,000 increase during the second quarter was primarily due to $600,000 in adverse loss development from the settlement of a claim in a discontinued commercial insurance program in the P&C segment.

Policy acquisition cost (commissions and amortization of deferred acquisition cost):

For the three months ended June 30, 2014, policy acquisition costs were $2,840,000 compared to $2,409,000 for the same period last year; an increase of $431,000. Policy acquisition costs consist of amortization of previously capitalized distribution costs, primarily commissions. Policy acquisition costs were up moderately due to a $300,000 increase in contingent commission accruals in the second quarter of 2014 compared to the same period last year.

General Expenses:

General and administrative expenses totaled $2,413,000 in the second quarter of 2014 compared to $2,162,000 in the second quarter of 2013; an 11.6% increase. The primary reason for the $251,000 increase in general and administrative expenses was a non-recurring payout of employee incentive compensation during the second quarter of 2014.

Taxes, licenses and fees:

Insurance taxes, licenses and fees were $521,000 for the three months ended June 30, 2014, compared to $474,000 for the same period last year. The primary reason for the increase was the 5.6% increase in gross premium written in the second quarter of 2014 compared to the same period last year. As a percentage of net premiums earned, insurance taxes, licenses and fees were 3.7% for the three months ended June 30, 2014 compared to 3.6% for the three months ended June 30, 2013.

Interest expense:

Interest expense for the second quarter of 2014 was $382,000 compared to $435,000 for the same period last year; a decrease of 12.2%. The primary reason for the $53,000 decline was a decrease in interest expense at the holding company level due to a reduction in long term debt during 2013.

Income taxes:

For the three month period ended June 30, 2014, the Company had pretax income of $1,844,000 with the primary component being $1,621,000 in tax-free life insurance benefit received from our company owned life insurance. Current income tax expense of $80,000 for the quarter primarily consisted of alternative minimum tax in the life insurance subsidiary and, combined with a $170,000 deferred tax benefit, resulted in a net income tax benefit of $90,000.

Net income:

The Company ended the second quarter of 2014 with net income of $1,934,000 compared to net income of $965,000 for the same period last year. As discussed above, the primary component of second quarter 20014 net income was $1,621,000 in tax-free life insurance benefit received from our company owned life insurance.

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Six months ended June 30, 2014 compared to six months ended June 30, 2013:

Premium revenue:

The table below provides earned premium revenue by segment for the six months ended June 30, 2014

and 2013:



	Six months ended June 30,						Percent
	2014			2013			increase (decrease)
Life, accident and health operations premiums earned:
Traditional life insurance	$	2,457		$	2,556		(3.9	)%
Accident and health insurance	862			882			(2.3	)%
Gross life, accident and health	3,319			3,438			(3.5	)%
Reinsurance premium ceded	(35		)	(30		)	16.7	%
Net life, accident and health premiums earned	$	3,284		$	3,408		(3.6	)%

Property and Casualty operations premiums earned:
Dwelling fire & extended coverage	$	15,580		$	14,274		9.1	%
Homeowners (Including mobile homeowners)	11,747			11,333			3.7	%
Ocean marine	—			524			(100.0	)%
Other liability	870			764			13.9	%
Gross property and casualty	28,197			26,895			4.8	%
Reinsurance premium ceded	(3,557		)	(4,331		)	(17.9	)%
Net property and casualty premiums earned	$	24,640		$	22,564		9.2	%

Gross premiums earned	$	31,516		$	30,333		3.9	%
Reinsurance premium ceded	(3,592		)	(4,361		)	(17.6	)%
Net premiums earned	$	27,924		$	25,972		7.5	%

Consolidated net premium revenue was up 7.5% for the six months ended June 30, 2014, at $27,924,000 compared to $25,972,000 for the six months ended June 30, 2013. The primary reason was a 4.8% increase in gross premium earned in the P&C segment from growth in the dwelling fire and homeowners property programs.

P&C segment net earned premium was also impacted by a 17.9% decline in ceded premium associated with a reduction in our catastrophe reinsurance rate under our January 1, 2014 catastrophe contract renewal. The Company maintains catastrophe reinsurance coverage to mitigate loss exposure from catastrophic events. Under our 2014 catastrophe contract renewal terms, our retention remained unchanged at $4 million and we maintain catastrophe reinsurance covering the cost incurred in a single catastrophe event up to $72.5 million after exceeding the $4 million retention.

Under the catastrophe reinsurance program for 2014, the Company retains the first $4,000,000 in losses from each event. Reinsurance coverage is maintained in four layers as follows:



Layer	Reinsurers' Limits of Liability
First Layer	100% of $6,000,000 in excess of $4,000,000
Second Layer	100% of $7,500,000 in excess of $10,000,000
Third Layer	100% of $25,000,000 in excess of $17,500,000
Fourth Layer	100% of $30,000,000 in excess of $42,500,000

Additional details regarding the structure of the current year agreement can be found in Note 10 to the consolidated financial statements.

Investment income:

For the six months ended June 30, 2014, net investment income totaled $1,978,000 compared to $1,734,000 for the same period last year; an increase of $244,000. Investment income is up for the year to date primarily due to an increase in invested assets.

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Realized investment gains and losses:

Realized capital gains in the first half of 2014 totaled $400,000 compared to $1,057,000 for the same period last year. The $657,000 decline was primarily associated with a reduction in the sale of securities in our investment portfolio. The realization of capital gains in the investment portfolio is influenced by both market conditions and liquidity requirements and therefore can vary significantly from quarter to quarter and year to year. Other activities, such as tax planning strategies, may also lead to significant variation in realized capital gains from year to year.

Other income:

Other income was $1,867,000 in 2014 compared to $317,000 in 2013; a $1,550,000 increase. The primary reason for the increase was a $1,621,000 non-recurring net gain from our company owned life insurance program. The remainder of other income consists primarily of fees related to the issuance of our property insurance policies as well as miscellaneous income.

Policyholder benefits:

Claims were $17,019,000 for the six months ended June 30, 2014, compared to $17,811,000 for the same period last year; a decrease of $792,000 or 4.4%. The primary reason for the decrease was a reduction in reported losses and LAE in the P&C segment from cat events as well as a reduction in reported losses and LAE in the P&C segment from non-catastrophe wind and hail claims in the current year compared to the same period last year. Offsetting the decline in claims from weather related events was a $618,000 increase in P&C segment reported fire losses for the six months ended June 30 2014, compared to the same period last year.

The table below provides a recap of P&C segment gross reported losses and LAE by catastrophe event and non-catastrophe wind and hail losses and LAE for the six months ended June 30, 2014 and 2013:



Six months ended June 30, 2014				Six months ended June 30, 2013
Cat event	Reported Losses & LAE		Claim Count	Cat event	Reported Losses & LAE		Claim Count
Cat 32 (Jan 5-8)	$	3,000	2	Cat 91 (Jan 29-31)	$	357,000	85
Cat 34 (Feb 11-14)	578,000		337	Cat 92 (Feb 24-25)	185,000		62
Cat 37 (Mar 27-29)	12,000		4	Cat 93 (Mar 18-19)	2,818,000		823
Cat 40 (Apr 27-May1)	1,682,000		357	Cat 94 (Mar 29-31)	67,000		18
Cat 43 (May 18-23)	148,000		57	Cat 95 (Apr 1-3)	33,000		9
Cat 45 (Jun 3-5)	31,000		13	Cat 99 (Apr 26-28)	76,000		18
				Cat 14 (May 18-22)	262,000		69
				Cat 15 (May 28-31)	159,000		48
				Cat 17 (Jun 12-14)	26,000		9
Total	$	2,454,000	770	Total	$	3,983,000	1,141

Non-cat wind & hail	$	3,299,000	1,154	Non-cat wind & hail	$	3,549,000	1,272

During the six months ended June 30, 2014, the P&C segment was impacted by six cat events totaling $2,454,000. The P&C subsidiaries incurred 770 claims from these cat events. These claims contributed 10 percentage points to the 2014 P&C segment loss ratio and had an average cost per claim of $3,200. During the six months June 30, 2013, the P&C segment was impacted by nine cat events totaling $3,983,000 resulting in 1,141 claims with an average per claim of $3,500. The cat events during the first six months of 2013 increased the prior year P&C segment loss ratio by 17.7 percentage points.

The largest 2014 cat event was Cat 40, occurring in the second quarter, with reported losses totaling $1,682,000 from 357 claims. Cat 40 added 6.8 percentage points to the 2014 P&C segment loss ratio. In comparison, the largest 2013 cat event was Cat 93, occurring in the first quarter of 2013, with reported losses totaling $2,818,000 from 823 claims. Cat 93 increased the 2013 P&C segment loss ratio 12.5 percentage points.

Non-catastrophe wind and hail claims reported in 2014 totaled $3,299,000 compared to non-catastrophe wind and hail claims reported in 2013 totaling $3,549,000; a decline of $250,000 or 7.0%. During 2014, the P&C segment had

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1,154 non-catastrophe wind and hail claims reported (an average of $2,900 per claim) compared to 1,272 claims reported during 2013 (an average of $2,800 per claim). Non-cat wind and hail claims reported during 2014 accounted for 19.4% of total incurred losses and LAE in the current year. Non-cat wind and hail claims reported during 2013 accounted for 19.9% of total incurred losses and LAE in the prior year.

Fire losses reported during 2014 were up $618,000 or 10.3% compared to fire losses reported during 2013. The P&C segment had 275 fire losses reported in 2014 totaling $6,595,000 compared to 262 fire losses reported during the same period last year totaling $5,977,000. The average cost per claim was $24,000 for fire losses reported in 2014 compared to $23,000 for fire losses reported in 2013.

Policy acquisition cost (commissions and amortization of deferred acquisition cost):

For the six months ended June 30, 2014, policy acquisition costs were $5,765,000 compared to $5,333,000 for the same period last year; an increase of $432,000. Policy acquisition costs consist of amortization of previously capitalized distribution costs, primarily commissions. Policy acquisition costs were up due to a $300,000 increase in contingent commission accruals in 2014 compared to the same period last year.

General Expenses:

General and administrative expenses totaled $4,439,000 in 2014 compared to $3,965,000 in 2013. A primary reason for the $474,000 increase in general and administrative expenses was the payout of employee incentive compensation in 2014 not incurred in 2013. In addition, we had a $125,000 increase in actuarial fees associated with insurance rate filings in the P&C segment and a policy reserve system conversion in the life segment.

Taxes, licenses and fees:

Insurance taxes, licenses and fees were $1,051,000 through June 30, 2014, compared to $960,000 for the same period last year. As a percentage of net premiums earned, insurance taxes, licenses and fees were 3.8% for the six months ended June 30, 2014 compared to 3.7% for the six months ended June 30, 2013.

Interest expense:

Interest expense for the first half of 2014 was $768,000 compared to $877,000 for the same period last year; a decrease of 12.4%. The primary reason for the $109,000 decline was a decrease in interest expense at the holding company level due to a reduction in long term debt during 2013.

Income taxes:

For the period ended June 30, 2014, the Company had pretax income of $3,127,000 compared to pretax income of $134,000 for the same period last year. The primary component of the current year pretax income was $1,621,000 gain from a tax-free life insurance benefit received under our company owned life insurance. Non-life taxable income was offset by net operating loss carryforwards so current income tax expense of $168,000 in 2014 and $220,000 in 2013 consisted primarily of life subsidiary alternative minimum tax.

Net income:

The Company ended the first half of 2014 with net income of $2,933,000 compared to net income of $556,000 for the same period last year. As discussed above, the primary component of current year net income was $1,621,000 in tax-free life insurance benefit received from our company owned life insurance. In addition, the P&C segment had much improved operating results with net premiums earned up 7.5% and claims down 4.4% in 2014 compared to the same period last year.

Liquidity and capital resources:

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

The liquidity requirements for the Company are primarily met by funds generated from operations of the life insurance and property/casualty insurance subsidiaries. All operations and virtually all investments are maintained by the insurance subsidiaries. Premium and investment income as well as maturities and sales of invested assets provide the primary sources of cash for both the life and property/casualty businesses, while applications of cash are applied

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by both businesses to the payment of policy benefits, the cost of acquiring new business (principally commissions), operating expenses, purchases of new investments, and in the case of life insurance, policy loans.

Virtually all invested assets of the Company are held in the insurance subsidiaries. As of June 30, 2014, the contractual maturity schedule for all bonds and notes held by the Company, stated at amortized cost, was as follows (dollars in thousands):



Maturity	Available- for-Sale		Held-to-Maturity		Total		Percentage of Total
Maturity in less than 1 year	$	1,379	$	—	$	1,379	1.66	%
Maturity in 1-5 years	16,015		201		16,216		19.61	%
Maturity in 5-10 years	29,227		154		29,381		35.52	%
Maturity after 10 years	35,363		373		35,736		43.21	%
	$	81,984	$	728	$	82,712	100.00	%

It should be noted that the above table represents maturities based on stated/contractual maturity. Due to call and prepayment features inherent in some debt securities and principal pay-downs on mortgage backed securities, actual repayment, or effective maturities, will differ from stated maturities. The Company routinely evaluates the impact of changing interest rates on the projected maturities of bonds in the portfolio and actively manages the portfolio in order to minimize the impact of interest rate risk. However, due to other factors, both regulatory and those associated with good investment management practices associated with asset/liability matching, we do have exposure to changes in market values of securities due to changes in interest rates. Currently, a 100 basis point immediate increase in interest rates would generate approximately a $4,600,000 decline in the market value of fixed income investment. Alternatively, a 100 basis point decrease in interest rates will generate approximately $4,200,000 in increases in market value of fixed income investments.

At June 30, 2014, the Company had aggregate equity capital, unrealized investment gains (net of income taxes) and retained earnings of $38,368,000, up $4,896,000 compared to $33,472,000 at December 31, 2013. Components of the change in equity were net income of $2,933,000, increase in accumulated unrealized gains on investments of $2,153,000, a net unrealized loss of $174,000 related to interest rate swaps and cash dividends paid totaling $149,000.

As discussed above, changing interest rates can have a significant impact on the market value of fixed income securities. Fixed income securities classified as available-for-sale increase the liquidity resources of the Company as they can be sold at any time to pay claims or meet other Company obligations. However, these securities are required to be carried at market value with net of tax accumulated unrealized gains and losses directly impacting shareholder's equity.

While the increase in interest rates causes near term declines in the value of fixed income securities, we are able to reap the benefit of reinvesting at higher rates as current fixed income investments are called, amortized (mortgage backed securities) or reach contractual maturity. Over the next twelve months, based on cash flow projection modeling that considers such factors as anticipated principal payments on mortgage backed securities, likelihood of call provisions being enacted and regular contractual maturities, we expect approximately 6.4% of our current fixed income portfolio to be reinvested or otherwise available to meet Company obligations.

The Company, primarily through its insurance subsidiaries, had $6,179,000 in cash and cash equivalents at June 30, 2014, compared to $3,841,000 at June 30, 2013. Improved performance in our insurance operations for the period ended June 30, 2014 contributed to the $4,297,000 in cash provided by operations compared to cash used in operations the same period last year totaling $2,408,000. Negative cash flows from operations in the prior year were related to insured losses from spring storms incurred during the first quarter.

Net cash used in investing activities totaled $2,567,000 for the period ended June 30, 2014, compared to $787,000 for the same period last year. At June 30, 2014, invested assets were up $6,148,000, or 6.1% compared to December 31, 2013. This increase was primarily the result of increases in market values of available for sale securities coupled with the reinvestment of proceeds from maturities of investments and the utilization of positive cash flows from operations to purchase available for sale securities. Cash used in investing activities in the prior year was related to the reinvestment of maturities.

Net cash used in financing activities totaled $538,000 for the period ended June 30, 2014, compared to net cash provided of $257,000 for the same period last year. During the six months ended June 30, 2014, the Company repaid a $700,000 short-term note payable which was renewed with a two-year term. As of June 30, 2014, a total of $9,333,000

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remained outstanding on the note associated with the Mobile Attic settlement with the next installment due in November of 2014 ($1,166,000) included in short-term notes payable. The Company maintains a $1,000,000 operating line of credit which matures in September 2017 as well as a $700,000 line of credit which matures in February of 2016. The Company had $1,075,000 available on lines of credit at June 30, 2014.

The Company had a total of $21,164,000 of long-term debt outstanding as of June 30, 2014, compared to $20,889,000 at December 31, 2013, which includes $12,372,000 in trust preferred securities issued by the Company in addition to the installment note and operating line of credit. The increase in long-term debt outstanding was related to the reclassification of a $700,000 operating line of credit from short-term to long-term debt. The Company had $625,000 drawn on operating lines of credit included in long-term debt at June 30, 2014.

The ability of the Company to meet its commitments for timely payment of claims and other expenses depends, in addition to current cash flow, on the liquidity of its investments. The Company has relatively little exposure to below investment grade fixed income investments, which might be especially subject to liquidity problems due to thinly traded markets.

The Company's liquidity requirements are primarily met by funds provided from operations of the insurance subsidiaries. The Company receives funds from its subsidiaries through payment of dividends, management fees, reimbursements for federal income taxes and reimbursement of expenses incurred at the corporate level for the subsidiaries. These funds are used to pay stockholder dividends, interest on debt, corporate administrative expenses, federal income taxes, and for funding investments in the subsidiaries. The Company maintains minimal liquidity in order to maximize liquidity within the insurance subsidiaries in order to support ongoing insurance operations. The Company has no separate source of revenue other than dividends and fees from the insurance subsidiaries. Also, dividends from the insurance subsidiaries are subject to regulatory restrictions and, therefore, are limited depending on capital levels and earnings of the subsidiaries.

Our P&C segment is the primary source of dividends to the holding company. Due to a combination of growth opportunities and continued risk of capital exposure to weather related events, management is maintaining a conservative stance with regard to paying of dividends to the holding company. Strengthening capital levels in the insurance subsidiaries remains a priority.

Dividends paid from the insurance subsidiaries are subject to regulatory restrictions and prior approval of the Alabama Department of Insurance. As disclosed in Note 12 to the audited Consolidated Financial Statements included in Our 2013 Annual Report on Form 10-K, the amount that The National Security Group's insurance subsidiaries can transfer in the form of dividends to the parent company during 2014 is limited to $1,463,000 in the life insurance subsidiary and $2,632,000 in the property/casualty insurance subsidiary. Dividends are limited to the greater of net income (operating income for life subsidiary) or 10% of statutory capital, and regulators consider dividends paid within the preceding twelve months when calculating the available dividend capacity. Therefore, all of the above referenced dividend capacity will not be available for consideration of payment until dividends paid in the preceding twelve months have been considered on a rolling basis. The Company also has to continuously evaluate other factors such as subsidiary operating performance, subsidiary capital requirements and potential impact by rating agencies in making decisions on how much capital can be released from insurance subsidiaries for payment of dividends to NSG. These factors are considered along with the goal of growing year over year statutory surplus in the subsidiaries, and these considerations along with previous adverse impacts on regulatory surplus, will likely lead to dividend payments to NSG substantially below the above referenced regulatory maximums. The Company had dividends receivable from its subsidiaries of $1,000,000 at June 30, 2014, payable on July 15, 2014.

The Company’s subsidiaries require cash in order to fund policy acquisition costs, claims, other policy benefits, interest expense, general expenses, and dividends to the Company. Premium and investment income, as well as maturities, calls, and sales of invested assets, provide the primary sources of cash for both subsidiaries. A significant portion of the Company’s investment portfolio, which is held by the insurance subsidiaries, consists of readily marketable securities, which can be sold for cash.

The Company continues to monitor liquidity and subsidiary capital closely. Improved underwriting results stemming from the discontinuation of unprofitable lines of business and streamlining of products offered combined with enhancements to the Company's rate development process and improvements in the Company's catastrophe reinsurance structure have reduced the pressure on subsidiary capital levels. However, due to modest levels of growth in premium revenue, it is still necessary to remain cautious and protect subsidiary capital.

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Except as discussed above, the Company is unaware of any known trends, events, or uncertainties reasonably likely to have a material effect on its liquidity, capital resources, or operations. Additionally, the Company has not been made aware of any recommendations of regulatory authorities, which if implemented, would have such an effect.

We have taken and will continue to take corrective action as necessary to improve our profitability and capital position. Over the past decade we have experienced a significant reduction in equity capital due to the adverse effects of six major hurricanes, the financial market meltdown in 2008, continued historically low interest rates, an unprecedented tornado outbreak in April of 2011 and the Mobile Attic litigation. While we are experiencing improvement and have put some major obstacles behind us, we are in a position where we believe it necessary to continue to preserve capital in the near term in order to put our Company in the best position to be successful moving forward. In order to maintain and improve our capital position, we will continue to monitor our dividend policy on a quarterly basis and should we encounter another significant adverse capital event we could take action which could include the suspension of shareholder dividends. Due to various factors discussed herein, we must remain flexible in our dividend policy until we achieve more consistent profitability and capital growth.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Under smaller reporting company rules we are not required to disclose information required under Item 7A. However, in order to provide information to our investors, we have elected to provide information related to market risk.

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

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

The Company is exposed to equity price risk on its equity securities. The Company holds common stock with a fair value of $4.9 million. Our portfolio has historically been highly correlated to the S&P 500 with regard to market risk. Based on an evaluation of the historical risk measure of our portfolio relative to the S&P 500, if the market value of the S&P 500 Index decreased 10% from its June 30, 2014 value, the fair value of the Company's common stock would decrease by approximately $490,000.

Certain fixed interest rate market risk sensitive instruments may not give rise to incremental income or loss during the period illustrated but may be subject to changes in fair values. Note 4 in the consolidated financial statements present additional disclosures concerning fair values of Financial Assets and Financial Liabilities and are incorporated by reference herein.

The Company limits the extent of its market risk by purchasing securities that are backed by 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 losing 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 capital for a sustained period of time, and low volatility rating (beta) relative to the market. The dividends provide a steady cash flow to help pay current claim liabilities, and it has been the Company's experience that by following this investment strategy, long term investment results have been superior to those offered by bonds, while keeping the risk of loss of capital to a minimum relative to the overall equity market.

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As for shifts in investment allocations, the Company has moderately increased allocations to corporate and tax free bonds. The improved yield spreads on corporate bonds has made this segment more attractive and the risk of investing in corporate bonds versus government bonds is more appropriately priced in our opinion. We have also increased our allocation to tax free securities to further enhance after-tax returns given our improved earnings performance over the last two years.

Item 4. Controls and Procedures

Our management carried out an evaluation, with the participation of our chief executive officer and chief financial officer, of the effectiveness of our disclosure controls and procedures as of June 30, 2014. Based upon that evaluation, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission.

There has not been any change in our internal control over financial reporting in connection with the evaluation required by Rule 13A-15(d) under the Exchange Act that occurred during the six month period ended June 30, 2014, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Part II. Other Information

Item 1. Legal Proceedings

Please refer to Note 13 to the consolidated financial statements included herein, and the 2013 Annual Report filed on Form 10-K.

Item 1A. Risk Factors

There has been no material change in risk factors previously disclosed under Item 1A. of the Company’s Annual Report for 2013 on Form 10-K.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

None

Item 3. Defaults Upon Senior Securities

None

Item 4. Mine Safety Disclosures

None

Item 5. Other Information

None

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Item 6. Exhibits

a. Exhibits



31.1	Certification Pursuant to 18 U. S. C. Section 1350, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2	Certification Pursuant to 18 U. S. C. Section 1350, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1	Certification Pursuant to 18 U. S. C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

101.INS	XBRL Instance Document

101.SCH	XBRL Taxonomy Extension Schema Document

101.CAL	XBRL Taxonomy Extension Calculation Linkbase Document

101.DEF	XBRL Taxonomy Extension Definition Linkbase Document

101.LAB	XBRL Taxonomy Extension Label Linkbase Document

101.PRE	XBRL Taxonomy Extension Presentation Linkbase Document

b. Reports on Form 8-K during the quarter ended June 30, 2014:



Date of Report	Date Filed	Description

April 11, 2014	April 11, 2014	Press release, dated April 11, 2014, issued by The National Security Group, Inc.

May 14, 2014	May 14, 2014	Press release, dated May 14, 2014, issued by The National Security Group, Inc.

May 16, 2014	May 20, 2014	Item 5.07 - announcement of annual meeting voting results.

Table of Contents

SIGNATURE

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

The National Security Group, Inc.



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

Date: August 13, 2014

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