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EX-32.1 - EXHIBIT 32.1 - NATIONAL SECURITY GROUP INCexhibit3216-30x2017.htm
EX-31.2 - EXHIBIT 31.2 - NATIONAL SECURITY GROUP INCexhibit3126-30x2017.htm
EX-31.1 - EXHIBIT 31.1 - NATIONAL SECURITY GROUP INCexhibit3116-30x2017.htm

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, 2017

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

Commission File Number 0-18649

image1a01a06.jpg
The National Security Group, Inc.
(Exact name of registrant as specified in its charter)

Delaware
 
63-1020300
(State or Other Jurisdiction of
Incorporation or Organization)
 
(IRS Employer
Identification No.)
 
 
 
661 East Davis Street
Elba, Alabama
 
36323
(Address of principal executive offices)
 
(Zip-Code)
 
Registrant’s Telephone Number including Area Code (334) 897-2273

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

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

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

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

As of August 11, 2017, there were 2,522,312 shares, $1.00 par value, of the registrant’s common stock outstanding.


1


THE NATIONAL SECURITY GROUP, INC.

TABLE OF CONTENTS

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


2


Cautionary Statement Regarding Forward-Looking Statements

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

The insurance industry is highly competitive and the Company encounters significant competition in all lines of business from other insurance companies. Many of the competing companies have more abundant financial resources than the Company.
Insurance is a highly regulated industry. It is possible that legislation may be enacted which would have an adverse effect on the Company's business.
The Company is subject to regulation by state governments for each of the states in which it conducts business. The Company cannot predict the subject of any future regulatory initiative(s) or its (their) impact on the Company's business. Company insurance rates are also subject to approval by state insurance departments in each of these states. We are often limited in the level of rate increases we can obtain.
The Company is rated by various insurance rating agencies. If a rating is downgraded from its current level by one of these agencies, sales of the Company's products and stock price could be adversely impacted.
The Company's financial results are adversely affected by increases in policy claims received by the Company. While a manageable risk, this fluctuation is often unpredictable.
The Company's investments are subject to a variety of risks. Investments are subject to defaults and changes in market value. Market value can be affected by changes in interest rates, market performance and the economy.
The Company mitigates risk associated with life policies through implementing effective underwriting and reinsurance strategies. These factors mitigate, not eliminate, risk related to mortality and morbidity exposure. The Company has established reserves for claims and future policy benefits based on amounts determined by independent actuaries. There is no assurance that these estimated reserves will prove to be sufficient or that the Company will not incur claims exceeding reserves, which could result in operating losses and loss of capital.
The Company mitigates risk associated with property and casualty policies through implementing effective underwriting and reinsurance strategies. The Company obtains reinsurance which increases underwriting capacity and limits the risk associated with policy claims. The Company is subject to credit risk with regard to reinsurers as reinsurance does not alleviate the Company's liability to its insured's for the ceded risks. The Company utilizes a third-party to develop a reinsurance treaty with reinsurers who are reliable and financially stable. However, there is no guarantee that booked reinsurance recoverable will actually be recovered. A reinsurer's insolvency or inability to make payments due could have a material adverse impact on the financial condition of the Company.
The Company's ability to continue to pay dividends to shareholders is contingent upon profitability and capital adequacy of the insurance subsidiaries. The insurance subsidiaries operate under regulatory restrictions that could limit the ability to fund future dividend payments of the Company. An adverse event or series of events could materially impact the ability of the insurance subsidiaries to fund future dividends, and consequently, the Board of Directors would have to suspend the declaration of dividends to shareholders.
The Company is subject to the risk of adverse settlements or judgments resulting from litigation of contested claims. It is difficult to predict or quantify the expected results of litigation because the outcome depends on decisions of the court and jury that are based on facts and legal arguments presented at the trial.


3


PART I. Financial Information
Item 1. Financial Statements

THE NATIONAL SECURITY GROUP, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS (In thousands)
 
 
June 30, 2017
 
December 31, 2016
 
 
(UNAUDITED)
 
 
ASSETS
 
 
 
 
Investments
 
 
 
 
Fixed maturities held-to-maturity, at amortized cost (estimated fair value: 2017 -
      $1,789; 2016 - $1,930)
 
$
1,741

 
$
1,890

Fixed maturities available-for-sale, at estimated fair value (cost: 2017 - $91,466;
2016 - $92,837)
 
92,649

 
92,792

Equity securities available-for-sale, at estimated fair value (cost: 2017 - $2,044;
2016 - $2,343)
 
4,699

 
4,943

Trading securities
 
107

 
107

Receivable for securities sold
 

 
499

Mortgage loans on real estate, at cost
 
164

 
174

Investment real estate, at book value
 
3,221

 
3,221

Policy loans
 
1,747

 
1,708

Company owned life insurance
 
4,920

 
4,864

Other invested assets
 
2,790

 
2,958

Total Investments
 
112,038

 
113,156

Cash and cash equivalents
 
8,005

 
7,368

Accrued investment income
 
733

 
776

Policy receivables and agents' balances, net
 
13,032

 
11,434

Reinsurance recoverable
 
506

 
1,780

Deferred policy acquisition costs
 
8,518

 
8,351

Property and equipment, net
 
1,852

 
1,880

Accrued income tax recoverable
 
1,839

 
941

Deferred income tax asset, net
 
2,145

 
2,402

Other assets
 
934

 
491

Total Assets
 
$
149,602

 
$
148,579

LIABILITIES AND SHAREHOLDERS' EQUITY
 
 

 
 

Property and casualty benefit and loss reserves
 
$
7,603

 
$
7,531

Accident and health benefit and loss reserves
 
3,385

 
3,405

Life and annuity benefit and loss reserves
 
32,945

 
32,633

Unearned premiums
 
32,474

 
29,968

Policy and contract claims
 
833

 
1,008

Other policyholder funds
 
1,669

 
1,629

Short-term notes payable and current portion of long-term debt
 
1,300

 
1,800

Long-term debt
 
15,332

 
15,326

Other liabilities
 
6,544

 
7,227

Total Liabilities
 
102,085

 
100,527

Contingencies
 


 


Shareholders' equity
 
 

 
 

Common stock
 
2,522

 
2,517

Additional paid-in capital
 
5,483

 
5,412

Accumulated other comprehensive income
 
1,963

 
1,007

Retained earnings
 
37,549

 
39,116

Total Shareholders' Equity
 
47,517

 
48,052

Total Liabilities and Shareholders' Equity
 
$
149,602

 
$
148,579

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

4


THE NATIONAL SECURITY GROUP, INC.

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

 
Three months ended
June 30,
 
Six months ended
June 30,
 
2017
 
2016
 
2017
 
2016
REVENUES
 
 
 
 
 
 
 
Net premiums earned
$
15,331

 
$
15,227

 
$
30,371

 
$
30,392

Net investment income
930

 
1,029

 
1,856

 
2,020

Net realized investment gains
77

 
242

 
237

 
249

Other income
145

 
150

 
297

 
304

Total Revenues
16,483

 
16,648

 
32,761

 
32,965

BENEFITS, LOSSES AND EXPENSES
 

 
 

 
 

 
 

Policyholder benefits and settlement expenses
12,581

 
8,862

 
23,727

 
17,909

Amortization of deferred policy acquisition costs
819

 
906

 
1,764

 
1,693

Commissions
1,758

 
2,117

 
3,851

 
4,225

General and administrative expenses
2,215

 
2,158

 
4,012

 
4,287

Taxes, licenses and fees
517

 
574

 
1,206

 
1,174

Interest expense
326

 
333

 
649

 
678

Total Benefits, Losses and Expenses
18,216

 
14,950

 
35,209

 
29,966

 
 
 
 
 
 
 
 
Income (Loss) Before Income Taxes
(1,733
)
 
1,698

 
(2,448
)
 
2,999

 
 
 
 
 
 
 
 
INCOME TAX EXPENSE (BENEFIT)
 

 
 

 
 

 
 

Current
(572
)
 
399

 
(897
)
 
620

Deferred
(162
)
 
3

 
(236
)
 
142

 
(734
)
 
402

 
(1,133
)
 
762

 
 
 
 
 
 
 
 
Net Income (Loss)
$
(999
)
 
$
1,296

 
$
(1,315
)
 
$
2,237

 
 
 
 
 
 
 
 
INCOME (LOSS) PER COMMON SHARE BASIC AND DILUTED
$
(0.39
)
 
$
0.52

 
$
(0.52
)
 
$
0.89

 
 
 
 
 
 
 
 
DIVIDENDS DECLARED PER SHARE
$
0.05

 
$
0.045

 
$
0.10

 
$
0.09



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


5


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,
 
2017
 
2016
 
2017
 
2016
 
 
 
 
 
 
 
 
Net income (loss)
$
(999
)
 
$
1,296

 
$
(1,315
)
 
$
2,237

 
 
 
 
 

 
 
Other comprehensive income (loss), net of tax
 
 
 
 
 
 
 
Changes in:
 
 
 
 
 
 
 
Unrealized gains on securities, net of reclassification adjustment of $155 and $172 for 2017 and 2016, respectively
502

 
1,130

 
846

 
2,288

Unrealized gain (loss) on interest rate swap
40

 
21

 
110

 
(81
)
 
 
 
 
 
 
 
 
Other comprehensive income, net of tax
542

 
1,151

 
956

 
2,207

 
 
 
 
 
 
 
 
Comprehensive income (loss)
$
(457
)
 
$
2,447

 
$
(359
)
 
$
4,444


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



6


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, 2016 (AUDITED)
$
48,052

 
$
39,116

 
$
1,007

 
$
2,517

 
$
5,412

 
 
 
 
 
 
 
 
 
 
Net loss for June 30, 2017
(1,315
)
 
(1,315
)
 

 

 

 
 
 
 
 
 
 
 
 
 
Other comprehensive income (net of tax)
956

 

 
956

 

 

 
 
 
 
 
 
 
 
 
 
Common stock issued
76

 

 

 
5

 
71

 
 
 
 
 
 
 
 
 
 
Cash dividends
(252
)
 
(252
)
 

 

 

 
 
 
 
 
 
 
 
 
 
Balance at June 30, 2017
$
47,517

 
$
37,549

 
$
1,963

 
$
2,522

 
$
5,483


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






7


THE NATIONAL SECURITY GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(In thousands)
 
Six months ended
June 30,
 
2017
 
2016
Cash Flows from Operating Activities
 
 
 
Net income (loss)
$
(1,315
)
 
$
2,237

Adjustments to reconcile net income to net cash provided by (used in) operating activities:
 
 
 

Depreciation expense and amortization/accretion, net
265

 
154

Decrease in cash surrender value of company owned life insurance
(56
)
 
(53
)
Net realized gains on investments
(237
)
 
(249
)
Deferred income taxes
(236
)
 
142

Amortization of deferred policy acquisition costs
1,764

 
1,693

Changes in assets and liabilities:
 
 
 
Change in receivable for securities sold
499

 

Change in accrued investment income
43

 
(6
)
Change in reinsurance recoverable
1,274

 
1,116

Policy acquisition costs deferred
(1,931
)
 
(1,898
)
Change in accrued income taxes
(898
)
 
(30
)
Change in net policy liabilities and claims
1,090

 
(1,319
)
Change in other assets/liabilities, net
(715
)
 
(436
)
Other, net
6

 
8

Net cash provided by (used in) operating activities
(447
)
 
1,359

Cash Flows from Investing Activities
 
 
 

Purchase of:
 
 
 
Available-for-sale securities
(8,467
)
 
(14,278
)
Property and equipment
(51
)
 
(84
)
Proceeds from sale or maturities of:
 
 
 
Held-to-maturity securities
139

 
213

Available-for-sale securities
10,202

 
10,317

Property and equipment
2

 

Other invested assets, net
(29
)
 
(29
)
Net cash provided by (used in) investing activities
1,796

 
(3,861
)
Cash Flows from Financing Activities
 

 
 

Change in other policyholder funds
40

 
28

Change in short-term notes payable
(500
)
 

Dividends paid
(252
)
 
(226
)
Net cash used in financing activities
(712
)
 
(198
)
Net change in cash and cash equivalents
637

 
(2,700
)
Cash and cash equivalents, beginning of year
7,368

 
6,763

Cash and cash equivalents, end of period
$
8,005

 
$
4,063

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

8


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2016 AMOUNTS)




NOTE 1 – SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation and Basis of Presentation
The accompanying condensed 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 condensed 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, 2016, 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 condensed consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Among the more significant estimates included in these condensed 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 2,518,520 at June 30, 2017 and 2,513,559 at June 30, 2016. The Company did not have any dilutive securities as of June 30, 2017 and 2016.

Reclassifications
Certain 2016 amounts have been reclassified from the prior year condensed consolidated financial statements to conform to the 2017 presentation.

Concentration of Credit Risk
The Company maintains cash balances which are generally held in non-interest bearing demand deposit accounts subject to FDIC insured limits of $250,000 per entity. At June 30, 2017, the net amount exceeding FDIC insured limits was $5,928,000 at two financial institutions. The Company has not experienced any losses in such accounts. Management of the Company reviews financial information of financial institutions on a quarterly basis and believes the Company is not exposed to any significant credit risk on cash and cash equivalents.

Policy receivables are reported at unpaid balances. Policy receivables are generally offset by associated unearned premium liabilities and are not subject to significant credit risk. Receivables from agents, less provision for credit losses, are composed of balances due from independent agents. At June 30, 2017, the single largest balance due from one agent totaled $1,142,000.

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, 2017 and December 31, 2016, 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, 2017, management does not believe the Company is exposed to any significant credit risk related to its reinsurance program.


9


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2016 AMOUNTS)



Accounting Changes Not Yet Adopted

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

Recognition and Measurement of Financial Assets and Financial Liabilities
In January 2016, the FASB issued guidance that requires equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. The guidance requires entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes and requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset. The guidance eliminates the requirement for public companies to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost. This guidance is effective for fiscal years beginning after December 15, 2017 and interim periods within those fiscal years. The Company does not expect the adoption to have a material impact on its financial position or results of operations.

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

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

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

Classification of Certain Cash Receipts and Cash Payments
In August 2016, the FASB issued guidance that clarifies how certain cash receipts and cash payments shall be presented and classified in the statement of cash flows. This guidance addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice. The guidance is effective for annual and interim reporting periods beginning after December 15, 2017. The Company does not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows.

10


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2016 AMOUNTS)




Receivables - Nonrefundable Fees and Other Costs
In March 2017, the FASB issued guidance that shortens the amortization period for certain callable debt securities held at a premium and requires the premium to be amortized to the earliest call date. The guidance is effective for fiscal years beginning after December 15, 2018 and interim reporting periods within those fiscal years. The Company does not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows.
 
Compensation - Stock Compensation
In May 2017, the FASB issued guidance to provide clarity and reduce diversity in practice as well as cost and complexity when there is a change in the terms or conditions of a share-based payment award. The guidance is effective for fiscal years beginning after December 15, 2017 and interim periods within those fiscal years. The Company does not expect adoption of this guidance to have a significant impact on our financial position, results of operations or cash flows.

Recently Adopted Accounting Standards

None

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 $228,000 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 condensed consolidated balance sheets as a component of long-term debt. The Company's equity investments in the Trust total $279,000 and are included in Other Assets in the accompanying consolidated balance sheets.

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


11


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2016 AMOUNTS)



NOTE 3 – INVESTMENTS

The amortized cost and aggregate fair values of investments in available-for-sale securities as of June 30, 2017 are as follows (dollars in thousands):
Available-for-sale securities:
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Corporate debt securities
 
$
39,520

 
$
1,200

 
$
722

 
$
39,998

Mortgage backed securities
 
10,238

 
134

 
191

 
10,181

Private label asset backed securities
 
9,962

 
281

 
18

 
10,225

Obligations of states and political subdivisions
 
13,268

 
498

 
74

 
13,692

U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
18,478

 
267

 
192

 
18,553

Total fixed maturities
 
91,466

 
2,380

 
1,197

 
92,649

Equity securities
 
2,044

 
2,655

 

 
4,699

Total
 
$
93,510

 
$
5,035

 
$
1,197

 
$
97,348


The amortized cost and aggregate fair values of investments in held-to-maturity securities as of June 30, 2017 are as follows (dollars in thousands):
Held-to-maturity securities:
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Mortgage backed securities
 
$
1,736

 
$
48

 
$

 
$
1,784

U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
5

 

 

 
5

Total
 
$
1,741

 
$
48

 
$

 
$
1,789


The amortized cost and aggregate fair values of investments in available-for-sale securities as of December 31, 2016 are as follows (dollars in thousands):
Available-for-sale securities:
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Corporate debt securities
 
$
40,533

 
$
748

 
$
878

 
$
40,403

Mortgage backed securities
 
10,970

 
134

 
173

 
10,931

Private label asset backed securities
 
7,910

 
29

 
165

 
7,774

Obligations of states and political subdivisions
 
14,806

 
507

 
147

 
15,166

U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
18,618

 
208

 
308

 
18,518

Total fixed maturities
 
92,837

 
1,626

 
1,671

 
92,792

Equity securities
 
2,343

 
2,628

 
28

 
4,943

Total
 
$
95,180

 
$
4,254

 
$
1,699

 
$
97,735


The amortized cost and aggregate fair values of investments in held-to-maturity securities as of December 31, 2016 are as follows (dollars in thousands):
Held-to-maturity securities:
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Mortgage backed securities
 
$
1,863

 
$
38

 
$

 
$
1,901

U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
27

 
2

 

 
29

Total
 
$
1,890

 
$
40

 
$

 
$
1,930



12


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2016 AMOUNTS)



The amortized cost and aggregate fair value of debt securities at June 30, 2017, 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
 
$
1,240

 
$
1,254

Due after one year through five years
 
15,766

 
15,881

Due after five years through ten years
 
32,905

 
33,456

Due after ten years
 
41,555

 
42,058

Total
 
$
91,466

 
$
92,649

 
 
 
 
 
Held-to-maturity securities:
 
 

 
 

Due in one year or less
 
$
13

 
$
13

Due after one year through five years
 
1

 
1

Due after five years through ten years
 
70

 
76

Due after ten years
 
1,657

 
1,699

Total
 
$
1,741

 
$
1,789


A summary of securities available-for-sale with unrealized losses as of June 30, 2017, along with the related fair value, aggregated by the length of time that investments have been in a continuous unrealized loss position, is as follows (dollars in thousands):
 
 
Less than 12 months
 
12 months or longer
 
Total
June 30, 2017
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Total
Securities in a Loss Position
Fixed maturities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
8,639

 
$
225

 
$
3,571

 
$
497

 
$
12,210

 
$
722

 
23

Mortgage backed securities
 
5,545

 
86

 
752

 
105

 
6,297

 
191

 
15

Private label asset backed securities
 
947

 
18

 

 

 
947

 
18

 
1

Obligations of state and political subdivisions
 
3,330

 
66

 
496

 
8

 
3,826

 
74

 
9

U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
8,548

 
155

 
1,316

 
37

 
9,864

 
192

 
13

 
 
$
27,009

 
$
550

 
$
6,135

 
$
647

 
$
33,144

 
$
1,197

 
61


There were no securities held-to-maturity with unrealized losses as of June 30, 2017.


13


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2016 AMOUNTS)



A summary of securities available-for-sale with unrealized losses as of December 31, 2016, 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, 2016
 
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
 
$
14,036

 
$
396

 
$
2,594

 
$
482

 
$
16,630

 
$
878

 
33
Mortgage backed securities
 
4,235

 
84

 
847

 
89

 
5,082

 
173

 
16
Private label asset backed securities
 
1,774

 
53

 
3,261

 
112

 
5,035

 
165

 
11
Obligations of state and political subdivisions
 
4,154

 
147

 

 

 
4,154

 
147

 
9
U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
11,421

 
294

 
291

 
14

 
11,712

 
308

 
16
Equity securities
 

 

 
1,258

 
28

 
1,258

 
28

 
1
 
 
$
35,620

 
$
974

 
$
8,251

 
$
725

 
$
43,871

 
$
1,699

 
86

There were no securities held-to-maturity with unrealized losses as of December 31, 2016.

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 approximately 6.44% 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, 2017 and year ended December 31, 2016, the Company realized no other-than-temporary impairments. At June 30, 2017, the single largest loss not realized as an impairment was in the bond portfolio and totaled $327,000. The second largest loss position was in the bond portfolio and totaled $86,000. The third largest loss position was in the bond portfolio and totaled $77,000. At December 31, 2016, the single largest loss not realized as an impairment was in the bond portfolio and totaled $340,000. The second largest loss position was in the bond portfolio and totaled $85,000. The third largest loss position was in the bond portfolio and totaled $66,000.



14


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2016 AMOUNTS)



Major categories of investment income are summarized as follows (dollars in thousands):
 
Three months ended
June 30,
 
Six months ended
June 30,
 
2017

2016
 
2017

2016
Fixed maturities
$
841

 
$
948

 
$
1,658

 
$
1,849

Equity securities
24

 
26

 
48

 
54

Mortgage loans on real estate
3

 
6

 
5

 
7

Investment real estate

 
2

 
2

 
4

Policy loans
33

 
32

 
66

 
64

Company owned life insurance change in surrender value
14

 
19

 
57

 
53

Other
42

 
26

 
87

 
75

 
957

 
1,059

 
1,923

 
2,106

Less: Investment expenses
27

 
30

 
67

 
86

Net investment income
$
930

 
$
1,029

 
$
1,856

 
$
2,020

Major categories of realized investment gains and losses are summarized as follows (dollars in thousands):
 
Three months ended
June 30,
 
Six months ended
June 30,
 
2017
 
2016
 
2017
 
2016
Fixed maturities
$
75

 
$
243

 
$
235

 
$
260

Other, principally real estate
2

 
(1
)
 
2

 
(11
)
Net realized investment gains
$
77

 
$
242

 
$
237

 
$
249

An analysis of the net change in unrealized appreciation on available-for-sale securities follows (dollars in thousands):
 
June 30,
2017
 
December 31, 2016
Net change in unrealized appreciation on available-for-sale securities before deferred tax
$
1,282

 
$
343

Deferred income tax
(436
)
 
(117
)
Net change in unrealized appreciation on available-for-sale securities
$
846

 
$
226


NOTE 4 – FAIR VALUE OF FINANCIAL ASSETS AND FINANCIAL LIABILITIES

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

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

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

The Company categorizes assets and liabilities carried at their fair value based upon a fair value hierarchy:
Level 1 – Quoted prices in active markets for identical assets or liabilities that the Company has the ability to access at the measurement date.


15


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2016 AMOUNTS)



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.

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, 2017 are summarized in the following table by the type of inputs applicable to the fair value measurements (in thousands):
 
 
Fair Value Measurements at Reporting Date Using
Description
 
Total
 
Level 1
 
Level 2
 
Level 3
Financial Assets
 
 
 
 
 
 
 
 
Fixed maturities available-for-sale
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
39,998

 
$

 
$
39,998

 
$

Mortgage backed securities
 
10,181

 

 
10,181

 

Private label asset backed securities
 
10,225

 

 
10,225

 

Obligations of states and political subdivisions
 
13,692

 

 
13,692

 

U.S. Treasury securities and obligations of U.S.
   Government corporations and agencies
 
18,553

 
18,553

 

 

Trading securities
 
107

 
107

 

 

Equity securities available-for-sale
 
4,699

 
3,657

 

 
1,042

Total Financial Assets
 
$
97,455

 
$
22,317

 
$
74,096

 
$
1,042

Financial Liabilities
 

 
 

 
 

 
 

Interest rate swap
 
$
(864
)
 
$

 
$

 
$
(864
)
Total Financial Liabilities
 
$
(864
)
 
$

 
$

 
$
(864
)


16


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2016 AMOUNTS)



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, 2017, Level 3 fair value measurements of assets include $1,042,000 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, 2017, Level 3 fair value measurements of liabilities include $864,000 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 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, 2017 (in thousands):

For the six months ended June 30, 2017
 
Equity Securities Available-for-Sale
 
Interest Rate Swap
Beginning balance
 
$
1,258

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

 
 

Included in earnings
 

 

Included in other comprehensive income
 
83

 
166

Purchases:
 
46

 

Sales:
 
(345
)
 

Issuances:
 

 

Settlements:
 

 

Transfers in/(out) of Level 3
 

 

Ending balance
 
$
1,042

 
$
(864
)
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, 2017:
 
$

 
$


For the six months ended June 30, 2017, there were no assets or liabilities measured at fair values on a nonrecurring basis.

17


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2016 AMOUNTS)



Financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2016 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
 
$
40,403

 
$

 
$
40,403

 
$

Mortgage backed securities
 
10,931

 

 
10,931

 

Private label asset backed securities
 
7,774

 

 
7,774

 

Obligations of states and political subdivisions
 
15,166

 

 
15,166

 

U.S. Treasury securities and obligations of U.S.
   Government corporations and agencies
 
18,518

 
18,518

 

 

Trading securities
 
107

 
107

 

 

Equity securities available-for-sale
 
4,943

 
3,685

 

 
1,258

Total Financial Assets
 
$
97,842

 
$
22,310

 
$
74,274

 
$
1,258

Financial Liabilities
 
 

 
 

 
 

 
 

Interest rate swap
 
$
(1,030
)
 
$

 
$

 
$
(1,030
)
Total Financial Liabilities
 
$
(1,030
)
 
$

 
$

 
$
(1,030
)

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, 2016 (in thousands):
For the year ended December 31, 2016
 
Equity Securities Available-for-Sale
 
Interest Rate Swap
Beginning balance
 
$
1,173

 
$
(1,419
)
Total gains or losses (realized and unrealized):
 
 

 
 

Included in earnings
 

 

Included in other comprehensive income
 
85

 
389

Purchases:
 

 

Sales:
 

 

Issuances:
 

 

Settlements:
 

 

Transfers in/(out) of Level 3
 

 

Ending balance
 
$
1,258

 
$
(1,030
)
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, 2016:
 
$

 
$


For the year ended December 31, 2016, 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

18


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2016 AMOUNTS)



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.

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

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

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

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

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

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

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

The carrying amount and estimated fair value of the Company’s financial instruments as of June 30, 2017 and December 31, 2016 are as follows (in thousands):
 
 
June 30, 2017
 
December 31, 2016
Assets and related instruments
 
Carrying
Value
 
Estimated
Fair Value
 
Carrying
Value
 
Estimated
Fair Value
Held-to-maturity securities
 
$
1,741

 
$
1,789

 
$
1,890

 
$
1,930

Mortgage loans
 
164

 
164

 
174

 
174

Policy loans
 
1,747

 
1,747

 
1,708

 
1,708

Company owned life insurance
 
4,920

 
4,920

 
4,864

 
4,864

Other invested assets
 
2,790

 
2,790

 
2,958

 
2,958

Liabilities and related instruments
 
 

 
 

 
 

 
 

Other policyholder funds
 
1,669

 
1,669

 
1,629

 
1,629

Short-term notes payable and current portion of long-term debt
 
1,300

 
1,300

 
1,800

 
1,800

Long-term debt
 
15,332

 
15,332

 
15,326

 
15,326


NOTE 5 – PROPERTY AND EQUIPMENT

Major categories of property and equipment are summarized as follows (dollars in thousands):
 
June 30, 2017
 
December 31, 2016
Building and improvements
$
3,379

 
$
3,348

Electronic data processing equipment
1,559

 
1,548

Furniture and fixtures
508

 
515

 
5,446

 
5,411

Less accumulated depreciation
3,594

 
3,531

Property and equipment, net
$
1,852

 
$
1,880

Depreciation expense for the six months ended June 30, 2017 was $79,000 ($159,000 for the year ended December 31, 2016).

19


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2016 AMOUNTS)



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 2011. Tax returns have been filed through the year 2015.

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 $2,145,000 at June 30, 2017 and $2,402,000 at December 31, 2016.

The tax effect of significant differences representing deferred tax assets and liabilities are as follows (dollars in thousands):
 
 
As of June 30,
 2017
 
As of December 31, 2016
General expenses
 
$
1,655

 
$
1,685

Unearned premiums
 
2,209

 
2,046

Claims liabilities
 
855

 
746

AMT credit
 
1,277

 
1,230

Impairment on real estate owned
 
187

 
187

Unrealized loss on interest rate swaps
 
294

 
350

Deferred tax assets
 
6,477

 
6,244

 
 
 
 
 
Depreciation
 
(131
)
 
(135
)
Deferred policy acquisition costs
 
(2,896
)
 
(2,839
)
Unrealized gains on securities available-for-sale
 
(1,305
)
 
(868
)
Deferred tax liabilities
 
(4,332
)
 
(3,842
)
Net deferred tax asset
 
$
2,145

 
$
2,402


The appropriate income tax effects of changes in temporary differences are as follows (dollars in thousands):
 
 
Six months ended June 30,
 
 
2017
 
2016
Deferred policy acquisition costs
 
$
57

 
$
69

Unearned premiums
 
(163
)
 
(154
)
General expenses
 
30

 
25

Depreciation
 
(4
)
 
4

Claims liabilities
 
(109
)
 
(75
)
AMT credit
 
(47
)
 
273

Deferred income tax expense (benefit)
 
$
(236
)
 
$
142



20


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2016 AMOUNTS)



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,
 
 
2017
 
2016
Federal income tax rate applied to pre-tax income/loss
 
34.0
 %
 
34.0
 %
Dividends received deduction and tax-exempt interest
 
1.4
 %
 
(1.5
)%
Company owned life insurance
 
0.8
 %
 
(0.6
)%
Small life deduction
 
11.5
 %
 
(5.4
)%
Other, net
 
(1.4
)%
 
(1.1
)%
Effective federal income tax rate
 
46.3
 %
 
25.4
 %

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, 2017 and December 31, 2016 (dollars in thousands):
 
 
June 30,
 
December 31,
 
 
2017
 
2016
Current portion of installment note payable $1,000,000 due March 2017 with $800,000 due November 2017 with variable interest rate equal to the WSJ prime rate plus 0.5%. Unsecured.
 
$
800

 
$
1,800

Line of credit, $1,000,000 available, with variable interest rate equal to the WSJ prime rate, subject to a 4.5% floor; maturity September 2017.  Interest payments due monthly.  Secured.
 

 

Line of credit with variable interest rate equal to the WSJ prime rate, subject to a 5.0% floor; maturity March 2018.  Interest payments due quarterly.  Unsecured.
 
500

 

 
 
$
1,300

 
$
1,800

Long-term debt consisted of the following as of June 30, 2017 and December 31, 2016 (dollars in thousands):
 
 
June 30,
 
December 31,
 
 
2017
 
2016
 
 
 
 
 
Promissory note with variable interest rate equal to the WSJ prime rate plus 0.5%; maturity November 2019. Annual installment payments beginning November 2017 with final balloon payment due November 30, 2019. Unsecured.
 
$
3,200

 
$
3,200

 
 
 
 
 
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; net of $173,000 in debt issuance cost ($178,000 in 2016); maturity December 2035.  Interest payments due quarterly.  All may be redeemed at any time following the tenth anniversary of issuance.  Unsecured.
 
9,106

 
9,101

 
 
 
 
 
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; net of $66,000 in debt issuance cost ($68,000 in 2016); maturity June 15, 2037. Interest payments due quarterly.  All may be redeemed at any time following the fifth anniversary of issuance.  Unsecured.
 
3,026

 
3,025

 
 
$
15,332

 
$
15,326


21


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2016 AMOUNTS)



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

The swaps entered into in 2009 and 2010 have fair values of $110,000 (liability) and $754,000 (liability), respectively, for a total liability of $864,000 at June 30, 2017 ($1,030,000 at December 31, 2016).  The swap liability is reported as a component of other liabilities on the consolidated balance sheets.  A net valuation gain of $110,000 (net of tax) is included in accumulated other comprehensive income related to the swap agreements at June 30, 2017.  A net valuation gain of $256,000 (net of tax) was included in accumulated other comprehensive income related to the swap at December 31, 2016.

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

The Company’s interest rate swaps include provisions requiring the Company to post collateral when the derivative is in a net liability position.  At June 30, 2017, the Company has securities on deposit with fair market values of $1,465,000 (all of which is posted as collateral). At December 31, 2016, the Company had securities on deposit with fair market values of $1,466,000 and cash of $231,000 (all of which is posted as collateral). See Note 4 for additional information about the interest rate swaps.


22


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2016 AMOUNTS)



NOTE 8 – POLICY AND CLAIM RESERVES

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

The following table is a reconciliation of beginning and ending property and casualty reserve balances for claims and claim adjustment expense (dollars in thousands):
 
 
Six months ended
June 30,
 
 
2017
 
2016
Summary of claims and claim adjustment expense reserves
 
 
 
 
Balance, beginning of year
 
$
7,531

 
$
9,645

Less reinsurance recoverable on unpaid losses
 
1,184

 
1,380

Net balances at beginning of year
 
6,347

 
8,265

Net losses:
 
 
 
 
Provision for claims and claim adjustment expenses for claims arising in current year
 
22,667

 
17,105

Estimated claims and claim adjustment expenses for claims arising in prior years
 
(1,202
)
 
(1,391
)
Total increases
 
21,465

 
15,714

Claims and claim adjustment expense payments for claims arising in:
 
 
 
 
Current year
 
18,033

 
13,154

Prior years
 
2,532

 
4,245

Total payments
 
20,565

 
17,399

Net balance at end of period
 
7,247

 
6,580

Plus reinsurance recoverable on unpaid losses
 
356

 
427

Claims and claim adjustment expense reserves at end of period
 
$
7,603

 
$
7,007


The increase in claim and claim adjustment expense reserves before reinsurance recoverable is primarily due to the increase in catastrophe losses during the period. The estimate for claims arising in prior years was reduced $1,202,000 in 2017 (reduced $1,391,000 in 2016) due to favorable loss development during the year on claims arising in prior years.

Accident and Health Claim Reserves

The Company, through its life insurance subsidiary, underwrites a limited number of short duration accident and health contracts. These claims are typically settled in three years or less and the reserve for unpaid claims totaled $306,000 at June 30, 2017 ($391,000 at December 31, 2016). These claims are a component of policy and contract claims which totaled $833,000 at June 30, 2017 ($1,008,000 at December 31, 2016).

NOTE 9 – 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 an excess of loss basis to cover losses from catastrophe events. Reinsurance ceded arrangements do not discharge the insurance subsidiaries as the primary insurer, except for cases involving a novation. Failure of re-insurers to honor their obligations could result in losses to the insurance subsidiaries. The insurance subsidiaries evaluate the financial conditions of their reinsurance companies and monitor concentrations of credit risk arising from similar geographic regions, activities,

23


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2016 AMOUNTS)



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

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

The Company's catastrophe reinsurance contract allows for one reinstatement. The Company maintains reinstatement premium protection (RPP) to cover reinstatement premiums incurred. The RPP further reduces risk from a major catastrophe and serves to 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.

At June 30, 2017, the largest reinsurance recoverable of a single reinsurer was $321,000 ($332,000 at December 31, 2016). Amounts reported as ceded incurred losses were related to development of losses from prior year catastrophes.

NOTE 10 – EMPLOYEE BENEFIT PLANS

The Company and its subsidiaries have an established retirement savings plan (401K Plan). All full-time employees are eligible to participate, and all employer contributions are fully vested for employees who have completed 1,000 hours of service in the year of contribution. Company matching contributions for the six months ended June 30, 2017 and 2016 amounted to $99,000 and $113,000, respectively. The Company contributes dollar-for-dollar matching contributions up to 5% of compensation subject to government limits.

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 to the non-qualified deferred compensation plans for the six months ended June 30, 2017 and 2016 amounted to approximately $143,000 and $107,000, 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

24


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2016 AMOUNTS)



other benefits to such employees. There were $268,000 costs incurred during the six months ended June 30, 2017 and $150,000 costs incurred during the six months ended June 30, 2016 related to ESOP plan contributions. All contributions were made in cash for purchase of Company shares in the open market. The Company has not allocated shares directly to the plan and the plan has no debt.

NOTE 11 – SHAREHOLDERS' EQUITY

During the six months ended June 30, 2017 and year ended December 31, 2016, changes in shareholders' equity consisted of net loss of $1,315,000 and net income of $3,063,000, respectively; dividends paid of $252,000 in 2017 and $452,000 in 2016; increases in accumulated other comprehensive income, net of applicable taxes, of $956,000 in 2017 and increases in accumulated other comprehensive income, net of applicable taxes, of $482,000 in 2016.  Other comprehensive gains and loss consisted of accumulated unrealized gains and losses on securities available-for-sale and unrealized loss on interest rate swaps.

Preferred Stock
Preferred Stock may be issued in one or more series as shall from time to time be determined and authorized by the Board of Directors. The directors may make specific provisions regarding (a) the voting rights, if any (b) whether such dividends are to be cumulative or noncumulative (c) the redemption provisions, if any (d) participating rights, if any (e) any sinking fund or other retirement provisions (f) dividend rates (g) the number of shares of such series and (h) liquidation preference.

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

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

The table below provides information regarding the Company's preferred and common stock as of June 30, 2017 and December 31, 2016:

 
June 30, 2017
 
December 31, 2016
 
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

 
2,522,312

 
2,522,312

 
3,000,000

 
2,517,339

 
2,517,339


On May 19, 2017, 4,973 shares of common stock were issued to directors as compensation under the 2009 Equity
Incentive Plan previously approved by shareholders.


25


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2016 AMOUNTS)



NOTE 12 – 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,
 
 
2017
 
2016
Gains and Losses on Cash Flow Hedges
 
 
 
 
Balance at beginning of period
 
$
(679
)
 
$
(935
)
Other comprehensive loss for period:
 
 
 
 
Other comprehensive gain (loss) before reclassifications
 
110

 
(81
)
Amounts reclassified from accumulated other comprehensive income
 

 

Net current period other comprehensive income (loss)
 
110

 
(81
)
Balance at end of period
 
$
(569
)
 
$
(1,016
)
Unrealized Gains and Losses on Available-for-Sale Securities
 
 
 
 
Balance at beginning of period
 
$
1,686

 
$
1,460

Other comprehensive income for period:
 
 
 
 
Other comprehensive income before reclassifications
 
1,001

 
2,460

Amounts reclassified from accumulated other comprehensive income
 
(155
)
 
(172
)
Net current period other comprehensive income
 
846

 
2,288

Balance at end of period
 
$
2,532

 
$
3,748

Total Accumulated Other Comprehensive Income at end of period
 
$
1,963