| NATIONAL SECURITY GROUP INC Item 1A Risk Factors Underwriting Underwriting is the first step in the Company’s risk management process |
| The insurance subsidiaries maintain underwriting departments that seek to evaluate the risks associated with the issuance of an insurance policy |
| NSIC accepts standard risks and, to an extent, substandard risks and engages medical doctors who review certain applications for insurance |
| In the case of the property-casualty subsidiaries, the underwriting staff attempts to assess, in light of the type of insurance sought by an applicant, the risks associated with a prospective insured or insurance situation |
| Depending upon the type of insurance involved, the process by which the risks are assessed will vary |
| In the case of automobile liability insurance, the underwriting staff assesses the risks involved in insuring a particular driver, and in the case of dwelling insurance, the underwriting staff assesses the risks involved in insuring a particular dwelling |
| Where possible, the underwriting staff of the property-casualty insurance subsidiary utilizes standard procedures as guides that quantify the hazards associated with a particular occupancy |
| In general, the property-casualty subsidiaries specialize in writing nonstandard risks |
| The nonstandard market in which the property-casualty subsidiaries operate reacts to general economic conditions in much the same way as the standard market |
| When insurers’ profits and equity are strong, companies generally cut rates or do not seek increases |
| Also, underwriting rules are less restrictive |
| As profit and/or capital fall, companies tighten underwriting rules, and seek rate increases |
| Premiums in the nonstandard market are higher than the standard market because of the increased risk of the insured, which generally comprises more frequent claims |
| Drivers of autos who have prior traffic convictions are one such increased risk that warrants higher premiums |
| Lower valued dwellings and mobile homes also warrant higher premiums because of the nature of the risk |
| The costs of placing such nonstandard policies and making risk determinations are similar to those of the standard market |
| The added costs due to more frequent claims servicing is reflected in the generally higher premiums that are charged |
| Reinsurance Reinsurance is the second step in the Company’s risk management process |
| Both insurance subsidiaries customarily reinsure with other insurers certain portions of the insurance risk |
| The primary purpose of such reinsurance arrangements is to enable the Company to limit its risk on individual policies, and in the case of property insurance, limit its risk in the event of a catastrophe in various geographic areas |
| A reinsurance arrangement does not discharge the issuing company from primary liability to the insured, and the issuing company is required to discharge its liability to the insured even if the reinsurer is unable to meet its obligations under the reinsurance arrangements |
| Reinsurance, however, does make the reinsurer liable to the issuing company to the extent of any reinsurance in force at the time of the loss |
| Reinsurance arrangements also decrease premiums retained by the issuing company since that company pays the reinsuring company a portion of total premiums based upon the amount of liability reinsured |
| NSIC generally reinsures all risks in excess of dlra50cmam000 with respect to any one insured |
| NSFC and Omega generally reinsure with third parties any liability in excess of dlra150cmam000 on any single policy |
| In addition, the property-casualty subsidiaries have catastrophe excess reinsurance, which provided protection in part with respect to aggregate property losses arising out of a single catastrophe, such as a hurricane |
| In 2005, the property-casualty subsidiaries had catastrophe protection up to a dlra37dtta5 million loss |
| Under the property and casualty subsidiaries reinsurance arrangement in force during 2005, the Company retained the first dlra2 million of insured losses from any single catastrophic event |
| The next dlra17dtta5 million in insured losses from any single event was 95prca reinsured with the Company’s net retention being 5prca |
| The final layer of reinsurance protection provided coverage for 100prca of insured losses exceeding 10 _________________________________________________________________ dlra17dtta5 million and up to dlra37dtta5 million |
| The amount of catastrophe reinsurance protection purchased by the Company was based on computer modeling of actual Company exposure |
| The Company generally seeks protection for worst case scenarios based on the computer modeling that mitigates losses up to a 1 in 250 year event, that is a loss that has less than a ½ of 1prca chance of occurring in any given year |
| NSFC and Omega had a provision for one reinstatement (coverage for two catastrophic events) during 2005 |
| In addition to catastrophe reinsurance, NSFC also had a 60prca quota share reinsurance agreement on ocean marine exposure with additional excess of loss coverage |
| Reserve liabilities NSIC maintains life insurance reserves for future policy benefits to meet future obligations under outstanding policies |
| These reserves are calculated to be sufficient to meet policy and contract obligations as they arise |
| Liabilities for future policy benefits are calculated using assumptions for interest, mortality, morbidity, expense, and withdrawals determined at the time the policies were issued |
| As of December 31, 2005, the total reserves of NSIC (including the reserves for accident and health insurance) were approximately dlra25 million |
| NSIC believes that such reserves for future policy benefits were calculated in accordance with generally accepted actuarial methods and that such reserves are adequate to provide for future policy benefits |
| Wakely Actuarial, consulting actuaries, provided actuarial services in calculating reserves |
| The property-casualty subsidiaries are also required to maintain loss reserves (claim liabilities) for all lines of insurance |
| Such reserves are intended to cover the probable ultimate cost of settling all claims, including those incurred but not yet reported |
| The reserves of the property-casualty subsidiaries reflect estimates of the liability with respect to incurred claims and are determined by evaluating reported claims on an ongoing basis and by estimating liabilities for incurred but not reported claims |
| Such reserves include adjustment expenses to cover the cost of investigating losses and defending lawsuits |
| The establishment of accurate reserves is complicated by the fact that claims in some lines of insurance are settled many years after the policies have been issued, thus raising the possibility that inflation may have a significant effect on the amount of ultimate loss payment, especially when compared to initial loss estimates |
| The subsidiaries, however, attempt to restrict their writing to risks that settle within one to four years of issuance of the policy |
| As of December 31, 2005, the property-casualty subsidiaries had reserves for unpaid claims of approximately dlra19dtta5 million before subtracting unpaid claims, which will be due from reinsurers of dlra8dtta6 million leaving net unpaid claims of dlra10dtta9 million |
| No changes were made in the assumptions used in estimating the reserves during the years ending December 31, 2005, 2004 or 2003 |
| The Company believes such reserves are adequate to provide for settlement of claims |
| Employees of the Company calculate NSFC and Omega loss reserves |
| Milliman, Inc, an independent actuarial consulting firm, reviews loss reserve estimates and issues a Statement of Actuarial Opinion regarding the adequacy of reserves |
| Financial Ratings The insurance subsidiaries are rated by AM Best Company, an insurance company-rating agency |
| NSFC is rated B++ (Very Good), Omega is rated B+ (Good) and NSIC is rated B (Fair) by AM Best Company |
| Regulation The insurance subsidiaries are each subject to regulation by the insurance departments of those states in which they are licensed to conduct business |
| Although the extent of regulation varies from state to state, the insurance laws of the various states generally establish supervisory departments having broad administrative powers with respect to, among other matters, the granting and revocation of licenses to transact business; the licensing of agents; the establishment of standards of financial solvency, including reserves to be maintained, the nature of investments and, in most cases premium rates; the approval of forms and policies; and the form and content of financial statements |
| These regulations have as their primary purpose the protection of policyholders and do not necessarily confer a benefit upon stockholders |
| Many states in which the insurance subsidiaries operate, including Alabama, have laws which require that insurers become members of guaranty associations |
| These associations guarantee that benefits due 11 ______________________________________________________________________ policyholders of insurance companies will continue to be provided even if the insurance company which wrote the business is financially unable to fulfill its obligations |
| To provide these benefits, the associations assess the insurance companies licensed in a state that write the line of insurance for which coverage is guaranteed |
| The amount of an insurer’s assessment is generally based on the relationship between that company’s premium volume in the state and the premium volume of all companies writing the particular line of insurance in the state |
| The Company has paid no material amounts to guaranty associations over the past three years |
| These payments, when made, are principally related to association costs incurred due to the insolvency of various insurance companies |
| Future assessments depend on the number and magnitude of insurance company insolvencies and such assessments are therefore difficult to predict |
| Most states have enacted legislation or adopted administrative rules and regulations covering such matters as the acquisition of control of insurance companies, transactions between insurance companies and the persons controlling them |
| The National Association of Insurance Commissioners has recommended model legislation on these subjects and all states where the Company’s subsidiaries transact business have adopted, with some modifications, that model legislation |
| These regulations have a direct impact on the Company since its cash flow is substantially derived from dividends from its subsidiaries |
| However, the Company has not had nor does it foresee a problem obtaining the necessary funds to operate because of the regulation |
| Statutory limitations of dividend payments by subsidiaries are disclosed in Note 12 to the accompanying Consolidated Financial Statements |
| Competition The insurance subsidiaries are engaged in a highly competitive business and compete with many insurance companies of substantially greater financial resources, including stock and mutual insurance companies |
| Mutual insurance companies return profits, if any, to policyholders rather than stockholders; therefore, mutual insurance companies may be able to charge lower net premiums than those charged by stock insurers |
| Accordingly, stock insurers must attempt to achieve competitive premium rates through greater volume, efficiency of operations and control of expenses |
| NSIC primarily markets its life and health insurance products through the home service system and independent producers |
| Direct competition comes from other home service companies and other insurance companies that utilize independent producers to sell insurance products, of which there are many |
| NSIC’s life and health products also compete with products sold by ordinary life companies |
| NSIC writes policies primarily in Alabama, Georgia and Mississippi |
| The market share of the total life and health premiums written is small because of the number of insurers in this highly competitive field |
| The primary methods of competition in the field are service and price |
| Because of the increased costs associated with a home service company, premium rates are generally higher than ordinary products, so competition from these ordinary insurers must be met through service |
| Initial costs of distribution through independent agents are generally more than through home service distribution methods, but lower commissions are paid in years subsequent to the first year of the policy so costs decline rapidly as policies renew after the first year |
| The primary factor in controlling cost under the independent agents distribution method is maintaining a high persistency rate |
| The persistency rate is the rate at which new business is maintained in renewal periods subsequent to the first year |
| The higher the persistency percentage that can be maintained, the lower overall distribution costs become due to lower commission rate payments on policies in force subsequent to the first year |
| The property-casualty subsidiaries market their products through independent agents and brokers, concentrating primarily on dwelling fire, homeowners and nonstandard auto coverage |
| NSFC, though one of the larger writers of lower value dwelling fire insurance in Alabama, nevertheless faces a number of competitors in this niche |
| Moreover, larger general line insurers also compete with NSFC The market share in states other than Alabama is small |
| Price is the primary method of competition |
| Due to the method of marketing through independent agents, commission rates and service to the agent are also important factors in whether the independent agent agrees to offer NSFC products over its competitors |
| Inflation 12 ______________________________________________________________________ The Company shares the same risks from inflation as other companies |
| Inflation causes operating expenses to increase and erodes the purchasing power of the Company’s assets |
| A large portion of the Company’s assets is invested in fixed maturity investments |
| The purchasing power of these investments will be less at maturity because of inflation |
| This is generally offset by the reserves that are a fixed liability and will be paid with cheaper dollars |
| Also, inflation tends to increase investment yields, which may reduce the impact of the increased operating expenses caused by inflation |