Financial Industries (FNIN) 10-Q 2005 Q2 Quarterly report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934 (FEE REQUIRED)

For the Quarterly Period Ended June 30, 2005

Commission File Number 0-4690

Financial Industries Corporation

(Exact name of registrant as specified in its charter)

TEXAS	74-2126975
State of Incorporation	(I.R.S. Employer Identification number)

6500 River Place Boulevard, Building I, Austin, Texas 78730

(Address including Zip Code of Principal Executive Offices)

(512) 404-5000

(Registrant's Telephone Number)

Securities Registered pursuant to Section 12(b) of the Act: None

Securities Registered pursuant to Section 12(g) of the Act:

Common Stock, $.20 par value

(Title of Class)

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

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act).

YES ¨ NO x

The number of shares outstanding of Registrant's common stock on December 31, 2006 was 10,208,339.

Forward-Looking Statements

Except for historical factual information set forth in this Form 10-Q of Financial Industries Corporation (the “Company” or “FIC”), the statements, analyses, and other information contained in this report relating to trends in the Company’s operations and financial results, the markets for our products, future results, the future development of our business, and the contingencies and uncertainties to which we may be subject, as well as other statements including words such as “anticipate,” “believe,” “plan,” “budget,” “could,” “designed,” “estimate,” “expect,” “intend,” “forecast,” “predict,” “project,” “may,” “might,” “should” and other similar expressions constitute forward-looking statements under the Private Securities Litigation Reform Act of 1995. Such statements are made based upon management’s current expectations and beliefs concerning financial results and economic conditions and are subject to known and unknown risks, uncertainties and other factors contemplated by the forward-looking statements. These factors include, among other things: (1) general economic conditions and other factors, including prevailing interest rate levels and stock market performance, which may affect the ability of FIC to sell its products, the market value of FIC’s investments and the lapse rate and profitability of policies; (2) FIC’s ability to achieve anticipated levels of operational efficiencies and cost-saving initiatives; (3) customer response to new products, distribution channels and marketing initiatives; (4) mortality, morbidity and other factors that may affect the profitability of FIC’s insurance products; (5) FIC’s ability to develop and maintain effective risk management policies and procedures and to maintain adequate reserves for future policy benefits and claims; (6) changes in the federal income tax laws and regulations that may affect the relative tax advantages of some of FIC’s products; (7) increasing competition in the sale of insurance; (8) the effect of regulation and regulatory changes or actions, including those relating to regulation of insurance products and insurance companies; (9) ratings assigned to FIC’s insurance subsidiaries by independent rating organizations such as A.M. Best Company, which FIC believes are particularly important to the sale of accumulation-type products; (10) the performance of our investment portfolios; (11) the effect of changes in standards of accounting; (12) the effects and results of litigation; (13) business risks and factors described elsewhere in this report, including, but not limited to, Item 2-Management’s Discussion and Analysis of Financial Condition and Results of Operations and Item 3-Quantitative and Qualitative Disclosures about Market Risks in Part 1, and Item 1-Legal Proceedings in Part 2, and (14) other factors discussed in the Company’s other filings with the SEC, which are available free of charge on the SEC’s website at www.sec.gov. You should read carefully the above factors and all of the other information contained in this report. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those indicated. All subsequent written and oral forward-looking statements attributable to the Company or to persons acting on our behalf are expressly qualified in their entirety by reference to these risks and uncertainties. There can be no assurance that other factors not currently anticipated by management will not also materially and adversely affect our results of operations. Each forward-looking statement speaks only as of the date of the particular statement and the Company undertakes no obligation to update or revise any forward-looking statement.

FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES

INDEX

	Page No.
Part I - Financial Information
Item 1. Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets June 30, 2005 and December 31, 2004	4
Condensed Consolidated Statements of Operations For the three and six month periods ended June 30, 2005 and June 30, 2004	6
Condensed Consolidated Statements of Cash Flows For the six month periods ended June 30, 2005 and June 30, 2004	10
Notes to Condensed Consolidated Financial Statements	12
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	22
Item 3. Quantitative and Qualitative Disclosures About Market Risk	30
Item 4. Controls and Procedures	31
Part II - Other Information
Item 1. Legal Proceedings	32
Item 2. Changes in Securities and Use of Proceeds	35
Item 3. Defaults Upon Senior Securities	35
Item 4. Submission of Matters to a Vote of Security Holders	35
Item 5. Other Information	35
Item 6. Exhibits and Reports on Form 8-K	36

FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands) (Unaudited)

	June 30, 2005		December 31, 2004 (1)
ASSETS
Investments:
Fixed maturity securities available for sale, at fair value (amortized cost of $552,636 and $500,701 at June 30, 2005 and December 31, 2004, respectively)	$	555,896	$	499,155
Fixed maturity securities held for trading, at fair value		342		1,057
Equity securities, at fair value (cost of $8,368 and $6,311 at June 30, 2005 and December 31, 2004, respectively)		10,414		8,502
Policy loans		38,755		39,855
Investment real estate		-		76,580
Real estate held for sale		371		589
Short-term investments		86,982		62,514
Total investments		692,760		688,252
Cash and cash equivalents		53,664		52,044
Deferred policy acquisition costs		47,781		50,640
Present value of future profits of acquired business		16,475		17,905
Agency advances and other receivables, net of allowances for doubtful accounts of $3,350 and $3,334 as of June 30, 2005 and December 31, 2004		9,050		10,539
Reinsurance receivables		39,763		36,912
Real estate held for use		-		13,559
Accrued investment income		6,543		5,652
Due premiums		1,885		2,045
Property and equipment, net		1,229		1,244
Other assets		2,195		2,089
Separate account assets		349,439		359,876
Total assets	$	1,220,784	$	1,240,757

(1) Derived from audited financial statements

The accompanying notes are an integral part of these condensed consolidated financial statements.

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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS, Continued

(In thousands) (Unaudited)

	June 30, 2005			December 31, 2004 (1)
LIABILITIES AND SHAREHOLDERS’ EQUITY
Liabilities:
Policy liabilities and contractholder deposit funds:
Contractholder deposit funds	$	558,047		$	572,090
Future policy benefits		157,341			160,175
Other policy claims and benefits payable		10,817			12,939
Notes payable		15,000			15,000
Deferred federal income taxes		6,191			3,549
Other liabilities		30,478			29,585
Separate account liabilities		349,439			359,876
Total liabilities		1,127,313			1,153,214
Commitments and contingencies (See Note 7)
Shareholders’ equity:
Common stock, $.20 par value, 25,000 shares authorized in 2005 and 2004, 12,517 shares issued in 2005 and 2004; 9,813 and 9,804 shares outstanding in 2005 and 2004		2,504			2,504
Additional paid-in capital		70,406			70,398
Accumulated other comprehensive loss		(2,364	)		(4,667	)
Retained earnings		46,189			42,650
Common treasury stock, at cost, 2,704 and 2,713 shares in 2005 and 2004		(23,264	)		(23,342	)
Total shareholders’ equity		93,471			87,543
Total liabilities and shareholders’ equity	$	1,220,784		$	1,240,757

(1) Derived from audited financial statements

The accompanying notes are an integral part of these condensed consolidated financial statements.

5

FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands except per share data) (Unaudited)

	Three Months Ended June 30,
	2005		2004
Revenues:
Premiums, net	$	5,877	$	5,685
Earned insurance charges		10,210		10,468
Net investment income		7,805		8,142
Real estate income		51		397
Net realized investment gains		8,910		(265	)
Other		674		497
Total revenues		33,527		24,924
Benefits and expenses:
Policyholder benefits and expenses		10,069		10,982
Interest expense on contractholders deposit funds		5,647		5,839
Amortization of deferred policy acquisition costs		3,170		2,910
Amortization of present value of future profits of acquired business		657		752
Operating expenses		7,404		8,801
Interest expense		277		210
Total benefits and expenses		27,224		29,494
Income (loss) from continuing operations before federal income taxes		6,303		(4,570	)
Provision (benefit) for federal income taxes		1,621		(774	)
Net income (loss)	$	4,682	$	(3,796	)

The accompanying notes are an integral part of these condensed consolidated financial statements.

6

FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS, Continued

(In thousands except per share data) (Unaudited)

	Three Months Ended June 30,
	2005		2004
Net Income (Loss) Per Share:
Basic:
Weighted average common shares outstanding		9,810		9,795
Basic earnings (loss) per share	$	0.48	$	(0.38	)
Diluted:
Weighted average common shares and common share equivalents		9,810		9,795
Diluted earnings (loss) per share	$	0.48	$	(0.38	)

The accompanying notes are an integral part of these condensed consolidated financial statements.

7

FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands except per share data) (Unaudited)

	Six Months Ended June 30,
	2005		2004
Revenues:
Premiums, net	$	11,981	$	12,435
Earned insurance charges		20,334		20,896
Net investment income		14,748		16,633
Real estate income		547		842
Net realized investment gains		9,270		1,854
Other		1,246		1,136
Total revenues		58,126		53,796
Benefits and expenses:
Policyholder benefits and expenses		19,936		24,349
Interest expense on contractholders deposit funds		11,147		11,746
Amortization of deferred policy acquisition costs		5,667		6,147
Amortization of present value of future profits of acquired business		1,323		1,698
Operating expenses		14,587		17,149
Interest expense		532		411
Total benefits and expenses		53,192		61,500
Income (loss) from continuing operations before federal income taxes and cumulative effect of change in accounting principle		4,934		(7,704	)
Provision (benefit) for federal income taxes		1,395		(1,408	)
Income (loss) before cumulative effect of change in accounting principle		3,539		(6,296	)
Cumulative effect of change in accounting principle		-		229
Net income (loss)	$	3,539	$	(6,067	)

The accompanying notes are an integral part of these condensed consolidated financial statements.

8

FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS, Continued

(In thousands except per share data) (Unaudited)

	Six Months Ended June 30,
	2005		2004
Net Income (Loss) Per Share:
Basic:
Weighted average common shares outstanding		9,808		9,793
Basic earnings per share:
Income (loss) from continuing operations before cumulative effect of change in accounting principle	$	0.36	$	(0.64	)
Cumulative effect of change in accounting principle		-		0.02
Net income (loss) per share	$	0.36	$	(0.62	)
Diluted:
Weighted average common shares and common share equivalents		9,808		9,793
Diluted earnings per share:
Income (loss) from continuing operations before cumulative effect of change in accounting principle	$	0.36	$	(0.64	)
Cumulative effect of change in accounting principle		-		0.02
Net income (loss) per share	$	0.36	$	(0.62	)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands) (Unaudited)

	Six Months Ended June 30,
	2005			2004
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)	$	3,539		$	(6,067	)
Adjustments to reconcile net income (loss) to net cash used in operating activities:
Amortization of deferred policy acquisition costs		5,667			6,147
Amortization of present value of future profits of acquired business		1,323			1,698
Net realized gains on investments		(9,270	)		(1,854	)
Depreciation		1,612			1,762
Increase in accrued investment income		(891	)		(473	)
Increase in agent advances and other receivables		(1,362	)		(10,742	)
Decrease in due premiums		160			60
Increase in deferred policy acquisition costs		(3,873	)		(3,397	)
Decrease (increase) in other assets		(106	)		702
Decrease in policy liabilities and accruals		(2,561	)		(2,246	)
Increase in other liabilities		893			3,400
(Decrease) increase in deferred federal income taxes		1,467			(382	)
Net activity from trading securities		647			3,053
Other, net		(1,656	)		(310	)
Net cash used in operating activities		(4,411	)		(8,649	)
CASH FLOWS FROM INVESTING ACTIVITIES:
Fixed maturities purchased		(91,429	)		(80,922	)
Real estate capital expenditures		(550	)		(64	)
Proceeds from sales and maturities of fixed maturities		37,507			104,705
Proceeds from sales of invested real estate		100,529			1,785
Net increase in short-term investments		(24,468	)		(49,849	)
Net decrease in policy loans		1,100			144
Purchase of property and equipment		(220	)		(300	)
Net cash provided by (used in) investing activities		22,469			(24,501	)
					(continued)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS, Continued

(In thousands) (Unaudited)

	Six Months Ended June 30,
	2005			2004
CASH FLOWS FROM FINANCING ACTIVITIES:
Contractholder fund deposits	$	17,362		$	22,925
Contractholder fund withdrawals		(33,800	)		(34,476	)
Net cash used in financing activities		(16,438	)		(11,551	)
Net increase (decrease) in cash		1,620			(44,701	)
Cash and cash equivalents, beginning of year		52,044			82,436
Cash and cash equivalents, end of period	$	53,664		$	37,735
Supplemental Cash Flow Disclosures:
Income taxes paid (refunded)	$	-		$	(1,093	)
Interest paid	$	517		$	411

The accompanying notes are an integral part of these condensed consolidated financial statements.

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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Basis of Presentation and Consolidation

The financial statements included herein have been presented to conform to the requirements of Form 10-Q.

Because of the delays in our public reporting and the significant changes we have made to our business in the interim, we have included certain information relating to our business, current officers, and related matters which have occurred subsequent to June 30, 2005.

The accompanying unaudited condensed consolidated financial statements reflect all adjustments (including normal recurring adjustments) necessary to present fairly the consolidated financial position of the Company at June 30, 2005, its consolidated results of operations for the three months and six months ended June 30, 2005 and 2004, and its consolidated cash flows for the six months ended June 30, 2005 and 2004 in conformity with accounting principles generally accepted in the United States of America (“GAAP”). Interim results are not necessarily indicative of full year performance. The December 31, 2004 condensed consolidated balance sheet data was derived from the audited financial statements included in the Company’s 2004 Annual Report on Form 10-K filed with the SEC (“2004 Annual Report”), which includes all disclosures required by GAAP. Therefore, these unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements of the Company included in the 2004 Annual Report.

The consolidated financial statements include the accounts of Financial Industries Corporation (“FIC”) and its wholly owned subsidiaries. All significant intercompany items and transactions have been eliminated.

1. Accumulated Other Comprehensive Income (Loss) and Comprehensive Income (Loss)

The following is a reconciliation of accumulated other comprehensive income (loss) from December 31, 2004 to June 30, 2005 (in thousands):

	Net Unrealized Appreciation (Depreciation) of Equity Securities			Net Unrealized Gain (Loss) on Fixed Maturities Available for Sale			Other			Total Accumulated Other Comprehensive Income (Loss)
Balance at December 31, 2004	$	1,446		$	(1,017	)	$	(5,096	)	$	(4,667	)
Current Period Change		(96	)		2,399			-			2,303
Balance at June 30, 2005	$	1,350		$	1,382		$	(5,096	)	$	(2,364	)

The comprehensive income (loss) for the three and six months ending June 30, 2005 and 2004 is summarized as follows (in thousands):

	Three Months Ended June 30,					Six Months Ended June 30,
	2005		2004			2005		2004
Net income (loss)	$	4,682	$	(3,796	)	$	3,539	$	(6,067	)
Other comprehensive income, net of tax:
Unrealized gains on securities:
Unrealized holdings gains (losses) arising during the period		5,631		(13,134	)		1,931		(7,860	)
Reclassification adjustments for gains (losses) included in net loss		135		(168	)		372		221
Total other comprehensive income (loss)		5,766		(13,302	)		2,303		(7,639	)
Comprehensive income (loss)	$	10,448	$	(17,098	)	$	5,842	$	(13,706	)

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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED

(Unaudited)

2. Change in Accounting Principles

The Company adopted the provisions of Statement of Position (“SOP”) 03-01, “Accounting and Reporting by Insurance Enterprises for Certain Non-traditional Long-Duration Contracts and for Separate Accounts” on January 1, 2004, resulting in an increase to income as a cumulative effect of a change in accounting principle totaling $229,000, net of taxes, as reflected in the accompanying 2004 condensed consolidated statement of operations for the six months ended June 30, 2004. The Company has certain universal life insurance products that are credited with bonus interest after applicable qualifying periods. The adoption of the new accounting principle resulted in a change in the pattern of recognition of the bonus interest expense.

3. Earnings Per Share

The following table reflects the calculation of basic and diluted earnings (loss) per share (amounts in thousands, except per share amounts):

	Three Months Ended June 30,					Six Months Ended June 30,
	2005		2004			2005		2004
	(in thousands except per share data)
BASIC:
Income (loss) before cumulative effect of change in accounting principle	$	4,682	$	(3,796	)	$	3,539	$	(6,296	)
Weighted average common shares outstanding		9,810		9,795			9,808		9,793
Basic income (loss) per share	$	0.48	$	(0.38	)	$	0.36	$	(0.64	)
DILUTED:
Income (loss) before cumulative effect of change in accounting principle	$	4,682	$	(3,796	)	$	3,539	$	(6,296	)
Weighted average common shares outstanding		9,810		9,795			9,808		9,793
Common stock options		-		-			-		-
Common stock and common stock equivalents		9,810		9,795			9,808		9,793
Diluted income (loss) per share	$	0.48	$	(0.38	)	$	0.36	$	(0.64	)

4. Net Realized Investment Gains - Sale of Real Estate

On June 1, 2005, the Company sold the River Place Pointe office complex to a non-affiliated party in an all-cash transaction for a gross purchase price of $103 million. The office complex is located in Austin, Texas. Under the terms of the sale agreement, the Company entered into a lease with the purchaser with respect to all of the space in Building One (approximately 76,000 square feet) for a five-year term at a rate of $28.00 per square foot, which was the prevailing rental rate at the time that FIC and its subsidiaries occupied the building in July 2000. The lease provides the Company with a right of cancellation of the lease at March 31, 2008. The Company will realize a gain of $10.6 million on the sale, which includes both a current realized gain of $8.5 million and a deferred gain of $2.1 million to be recognized as a reduction of office lease expenses over the period from the sale date through March 31, 2008.

5. Retirement Plans

A. Family Life

Family Life has a non-contributory defined benefit pension plan (“Family Life Pension Plan”), which covers employees who have completed one year or more of service. Under the Family Life Pension Plan, benefits are payable upon retirement based on earnings and years of credited service.

a. The Normal Retirement Date for all employees is the first day of the month coinciding with or next following the later of attainment of age 65 or the fifth anniversary of employment.

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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED

(Unaudited)

b. The Normal Retirement Benefit is the actuarial equivalent of a life annuity, payable monthly, with the first payment commencing on the Normal Retirement Date. The life annuity is equal to the sum of (1) plus (2):

(1) Annual Past Service Benefit: 1.17% of the first $10,000 of Average Final Earnings plus 1 1/2% of the excess of Average Final Earnings over $10,000, all multiplied by the participant’s Credited Past Service. For these purposes, “credited past service” is service prior to April 1, 1967, with respect to employees who were plan participants on December 31, 1975.

(2) Annual Future Service Benefit: 1.5578% of the first $10,000 of Average Final Earnings plus 2% of the excess of Average Final Earnings over $10,000, all multiplied by the participant’s Credited Future Service.

c. Effective April 1, 1997, the Family Life Pension Plan was amended to provide that the accrual rate for future service is 1.57% of Final Average Earnings multiplied by Credited Service after March 31, 1997, less 0.65% of Final Average Earnings up to Covered Compensation. With respect to service prior to April 1, 1997, the accrual rate described in paragraph (b), above, is applicable, with Average Final Earnings taking into account a participant’s earnings subsequent to April 1, 1997.

d. Effective March 31, 2004, all employees covered under the plan were terminated. No new employees are permitted to enter or re-enter the plan.

Average Final Earnings are the highest average Considered Earnings during any five consecutive years while an active participant. Total Credited Past Service plus Credited Future Service is limited to 30 years.

A curtailment occurred on January 1, 2004 when the decision was made to terminate the employment of all active participants in the plan as discussed in item (d) above. Because the plan’s unrecognized losses exceeded the decrease in projected benefit obligation (“PBO”) caused by the curtailment as of January 1, 2004, the SFAS No. 88 curtailment charge recognized in the 2004 expense was zero. (The plan was subsequently amended to prevent any new or rehired employee from entering or reentering the plan in the future. Thus, the plan is now frozen.)

A settlement occurred on December 31, 2004 due to the settlement of several former employees’ plan obligations through the payment of lump sums. A settlement occurs whenever the lump sums paid during the year exceed the sum of the plans Service Cost and Interest Cost components of expense for that year. The settlement resulted in the recognition of a $399,000 charge to expense for 2004.

The pension costs for the Family Life Pension Plan include the following components at June 30, 2005:

	Three Months Ended June 30,						Six Months Ended June 30,
	2005			2004			2005			2004
Service cost for benefits earned during the year	$	-		$	-		$	-		$	-
Interest cost on projected benefit obligation		116,054			126,983			232,108			253,966
Expected return on plan assets		(101,269	)		(108,056	)		(202,537	)		(216,112	)
Amortization of unrecognized prior service cost		-			-			-			-
Amortization of unrecognized (gains)/losses		26,226			19,276			52,452			38,552
Recognition of net loss due to settlement		-			-			-			-
Net periodic benefit cost	$	41,011		$	38,203		$	82,023		$	76,406

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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED

(Unaudited)

B. ILCO

ILCO maintains a retirement plan (“ILCO Pension Plan”) covering substantially all employees of the Company and its subsidiaries. The ILCO Pension Plan is a non-contributory, defined benefit pension plan, which covers each eligible employee who has attained 21 years of age and has completed one year or more of service. Each participating subsidiary company contributes an amount necessary (as actuarially determined) to fund the benefits provided for its participating employees.

The ILCO Pension Plan’s basic retirement income benefit at normal retirement age is 1.57% of the participant’s average annual earnings less 0.65% of the participant’s final average earnings up to covered compensation multiplied by the number of his/her years of credited service. For participants who previously participated in the ILCO Pension Plan maintained by ILCO for the benefit of former employees of the IIP Division of CIGNA Corporation (the IIP Plan), the benefit formula described above applies to service subsequent to May 31, 1996. With respect to service prior to that date, the benefit formula provided by the IIP Plan is applicable, with certain exceptions applicable to former IIP employees who are classified as highly compensated employees.

Former eligible IIP employees commenced participation automatically. The ILCO Pension Plan also provides for early retirement, postponed retirement, and disability benefits to eligible employees. Participant benefits become fully vested upon completion of five years of service, as defined, or attainment of normal retirement age, if earlier.

A curtailment occurred on December 31, 2004 when the plan was amended to freeze accrued benefits for all participants except for Rule of 68 Non-Highly Compensated Employees (NHCEs). (A Rule of 68 Participant is a Participant who was an Employee on December 31, 2004 and for whom the sum of the Participant’s age in years and fractions thereof and service in years and fractions thereof was greater than or equal to 68 years as of December 31, 2004. A Rule of 68 NHCE is a Rule of 68 Participant who was not a Highly Compensated Employee, as defined under IRC Section 414(q), as of December 31, 2004.) Because the plan’s unrecognized losses exceeded the decrease in PBO caused by the curtailment as of December 31, 2004, the SFAS No. 88 curtailment charge recognized in the 2004 expense was zero.

The pension costs for the ILCO Pension Plan include the following components at June 30, 2005:

	Three Months Ended June 30,						Six Months Ended June 30,
	2005			2004			2005			2004
Service cost for benefits earned during the year	$	11,448		$	145,556		$	22,896		$	291,112
Interest cost on projected benefit obligation		261,812			283,352			523,624			566,704
Expected return on plan assets		(344,766	)		(342,053	)		(689,532	)		(684,106	)
Amortization of unrecognized prior service cost		-			-			-			-
Amortization of unrecognized (gains)/losses		33,920			43,775			67,840			87,550
Recognition of net loss due to settlement		-			-			-			-
Net periodic benefit cost	$	(37,586	)	$	130,630		$	(75,172	)	$	261,260

6. Stock Option Plans and Other Equity Incentive Plans

The Company follows the disclosure-only provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock Based Compensation - Transition and Disclosure.” SFAS No. 123 allows companies to follow existing accounting rules (APB 25) provided that pro forma disclosures are made of what net income and earnings per share would have been had the company recognized expense for stock-based awards based on their fair value at date of grant. The fair value disclosure assumes that fair value of option grants were calculated at the date of the grant using the Black-Scholes option pricing model. No options were granted to employees for the years ended December 31, 2005 and 2004.

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(Unaudited)

In December 2004, the FASB issued SFAS No. 123(R), “Share-Based Payment.” SFAS 123(R) is a revision of SFAS 123, “Accounting for Stock-Based Compensation,” which was originally issued by the FASB in 1995. As originally issued, SFAS 123 provided companies with the option to either record expense for share-based payments under a fair value model, or to simply disclose the impact of the expense. SFAS 123(R) requires companies to measure the cost of share-based payments to employees using a fair value model, and to recognize that cost over the relevant service period. In addition, SFAS 123(R) requires that an estimate of future award forfeitures be made at the grant date, while SFAS 123 permitted recognition of forfeitures on an as incurred basis. SFAS 123(R) was originally effective July 1, 2005 but later deferred by the Securities and Exchange Commission to January 1, 2006. The adoption of this statement is not expected to have any material impact on the Company’s consolidated financial statements.

7. Commitments and Contingencies

Mitte Settlement

In 2002, the Company filed a lawsuit against Roy F. Mitte (“Mitte”), The Roy F. and Joann Cole Mitte Foundation (the “Foundation”), and Joann Mitte (collectively referred to as the “Defendants”). Mitte was the Chairman, President and Chief Executive Officer of FIC until he was placed on administrative leave in August, 2002. The administrative leave, and the subsequent action by the Board of Directors in October, 2002, to terminate the employment agreement between the Company and Mitte, resulted from an investigation conducted by the FIC Audit Committee. Subsequent to the filing of the lawsuit, Mitte filed a counterclaim against the Company alleging that the Company breached the employment agreement between the Company and Mr. Mitte by refusing to pay Mitte the severance benefits and compensation provided for under the employment agreement and amendment thereto.

On May 15, 2003, the Company entered into a settlement agreement with the Defendants and Scott Mitte (a director of the Company and the son of Roy Mitte) (the “Mitte Parties”). Under the terms of the agreement the Mitte Parties released the Company from any past, present or future claims which they may have against the Company, including any claims which Roy Mitte may assert under his employment agreement. In addition, the Company agreed to release the Mitte Parties from any past, present or future claims which the Company may have against the Mitte Parties.

The settlement provides for payments aggregating $3 million by the Company to Roy Mitte in equal installments of $1 million on June 1, 2003, June 1, 2004 and June 1, 2005, with a provision for acceleration of payments in the event of a change in control. The settlement agreement also includes provisions whereby, the Company agrees (i) to use reasonable efforts to locate purchasers over a two-year period for 1,552,206 shares of FIC common stock owned by the Foundation at a price of $14.64 per share, (ii) to purchase (or, alternatively, locate a purchaser) on or before June 1, 2003 for 39,820 shares of FIC common stock owned by Roy Mitte and 35,502 shares of common stock held in the ESOP account of Roy Mitte, at a price of $14.64 per share. The agreement also includes provisions related to the continuation of health insurance of Roy and Joann Mitte and payment for the cancellation of options held by Roy Mitte to purchase 6,600 shares of FIC common stock. The Company has recognized a charge of $2.9 million in 2003 for the discounted amounts to be paid under the settlement agreement, which is reflected in the consolidated statement of operations for the six months ended June 30, 2003, as litigation settlement.

As a condition of the obligations of the Company under the settlement agreement, the Mitte Parties agreed to grant a limited proxy to the persons named as proxies by FIC in any proxy statement filed by FIC with the SEC. With respect to the future shareholders meetings, the proxy may be voted “for” all nominees for the Board of Directors named on FIC’s proxy statement, “against” any proposal by a person other than FIC for the removal of any members of the Board of Directors, “withheld” as to nominees for the Board of Directors proposed by any person other than FIC and “against” any proposal by any person other than FIC to amend the bylaws or articles of FIC. The proxy also extends to certain matters which may be proposed by FIC at the 2004 annual meeting of shareholders, or any later annual or special meeting, regarding changes in the ownership percentage required in order for a shareholder to call a special meeting of shareholders and the elimination of cumulative voting. The granting of the proxy is generally conditioned upon the performance of the scheduled purchases of the shares of FIC common stock owned by the Foundation.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED

(Unaudited)

T. David Porter v. Financial Industries Corporation

On May 31, 2006, T. David Porter, an FIC shareholder, filed a civil suit in Travis County, Texas District Court (the “Court”), against the Company, seeking to compel the Company to hold an annual meeting of shareholders. FIC has been unable to hold an annual meeting at which its shareholders could be fully informed, or which could be attended by a substantial portion of its shareholders, because the Company is currently unable to comply with Rule 14a-3 of the Securities Exchange Act of 1934, and thus cannot provide an annual report to shareholders or solicit proxies in connection with an annual meeting. Mr. Porter sued under Article 2.24(B) of the Texas Business Corporation Act, which provides that if an annual meeting of shareholders is not held within any 13-month period and a written consent of shareholders has not been executed instead of a meeting, any court of competent jurisdiction in the county in which the principal office of the corporation is located may, on the application of any shareholder, summarily order a meeting to be held. On August 7, 2006, the Company entered into an Agreed Order On Plaintiff’s Motion to Compel Annual Shareholders Meeting (the “Order”) and agreed among other things to hold an annual shareholders meeting for the election of directors on December 6, 2006. The Company did in fact appear for a meeting of shareholders on December 6, 2006, as required by the Agreed Order. In advance of the meeting date, a group affiliated with Mr. Porter solicited proxies from FIC shareholders in an effort to replace FIC’s Board of Directors; the Company remained unable to solicit proxies. However, on the appointed day for the shareholder meeting - December 6, 2006 - a quorum was not in attendance. On December 12, 2006, FIC filed a Motion for Summary Judgment seeking dismissal of Porter’s suit on the grounds that the Agreed Order did not dispense with the requirement of a quorum; the lack of a quorum was a direct and foreseeable result of Mr. Porter’s insistence on a one-sided solicitation and election; FIC has complied with its obligations under the Agreed Order and Mr. Porter has obtained all relief sought by his petition. FIC’s Motion for Summary Judgment remains pending and has not been heard. Mr. Porter thereafter applied for a temporary restraining order and temporary injunction requiring the Company to convene one or more additional meetings of shareholders, contending that in the absence of a quorum on December 6, Texas law and the Company’s bylaws entitled a majority of the shareholders in attendance to choose a date to which the meeting would be adjourned. The District Court held a hearing on Porter’s application, and on December 22, 2006 entered an order providing among other things that FIC will hold an annual shareholders meeting for the election of directors on January 16, 2007 at 10:00 a.m., but that if a quorum is not present on that date, FIC will not be required to hold an annual meeting of shareholders at any time before July 17, 2007. In compliance with the December 22, 2006 order, FIC has mailed new notices of the January 16, 2007 meeting to all shareholders of record as of the October 24, 2006 Record Date.

Litigation with Otter Creek Partnership I, L.P.

During 2003, Otter Creek Management Inc., (“Otter Creek Management”), solicited proxies for the Company’s 2003 Annual Meeting of Stockholders (the “2003 Annual Meeting”) held on July 31, 2003, seeking the election of seven nominees to the Board of Directors of the Company in opposition to the ten candidates selected by the then incumbent Board of Directors. Otter Creek Management is an investment advisory firm that manages three investment funds that are shareholders of the Company: Otter Creek Partners I, LP (“Otter Creek Partners”), Otter Creek International Ltd. and HHMI XIII, LLC (together with Otter Creek Management and Otter Creek Partners, “Otter Creek”).

In connection with this solicitation of proxies, on June 13, 2003, Otter Creek Partners commenced a lawsuit in the District Court in Travis County, Texas, Cause No. GN302872 (the “Litigation”) seeking, among other things, to compel the Company to hold the previously delayed 2003 Annual Meeting. Otter Creek also sought in the Litigation to neutralize the effect of a proxy obtained by the Company from the Mitte Family (the “Mitte Proxy”) the preceding month whereby the incumbent board was able to vote 1,627,610 shares in favor of its nominees.

Following the initiation of this litigation and a hearing before the court, the court ordered the Company not to amend its bylaws in a manner that would adversely affect voting or other matters relating to the Annual Meeting and election of directors and not to reschedule such Annual Meeting scheduled for July 31, 2003, or the record date of the Annual Meeting.

At the meeting, six of the seven Otter Creek nominees were elected to the Board: R. Keith Long, J. Bruce Boisture, Salvador Diaz-Verson Jr., Patrick E. Falconio, Richard H. Gudeman and Lonnie L. Steffen. The shares covered by the Mitte Proxy were all voted in favor of the incumbent nominees at the 2003 Annual Meeting. Had Otter Creek been successful in neutralizing the effect of the Mitte Proxy, all seven of the Otter Creek nominees would have been elected.

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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED

(Unaudited)

Following the 2003 Annual Meeting, Otter Creek and FIC completed a settlement with respect to the lawsuit in December 2003. Under the settlement agreement, the Company reimbursed Otter Creek for $250,000 in proxy expenses in 2003. An additional $475,000 of proxy and litigation expenses payable in FIC common stock will be submitted to the Company’s shareholders for approval at the next Annual Meeting of Shareholders. If payment of the additional $475,000 is so approved, the amount will be expensed by the Company in the year of approval. The Board of Directors will recommend that shareholders approve the reimbursement. The settlement also included mutual releases between the Company and Otter Creek and its affiliates. The Chairman of the Board of Directors of the Company, R. Keith Long, is the President and owner of the General Partner of Otter Creek Partners I, L.P.

Litigation with Former Employee of Subsidiary

In October 2003, the Company placed Earl Johnson, the then-president of JNT Group, Inc. (“JNT”), a subsidiary of FIC that was later sold in December 2003 in the sale of the New Era companies, on administrative leave pending an investigation of matters related to (1) Johnson’s alleged termination of an employee in response to her request for information regarding her workers’ compensation rights arising out of an injury and (2) his co-mingled and disorganized bookkeeping of JNT’s client accounts with those of a personal business owned by Mr. Johnson and run by him at the same office (using the Company’s employees to do so). Soon after being interviewed in the course of that investigation, Mr. Johnson resigned, alleging good reason under his employment agreement with a subsidiary of FIC, on the ground that the change in the composition of the Board of Directors of FIC following the 2003 Annual Meeting of Shareholders resulted in a “change of control” under the provisions of his employment agreement. The employment agreement provided that if Mr. Johnson were to voluntarily terminate his employment for good reason, he would receive compensation and benefits for the remainder of the three-year term of the agreement and would become fully vested in 17,899 restricted shares of FIC stock. The Company notified Mr. Johnson that his resignation was not for “good reason” pursuant to his employment agreement. Under that agreement, termination without good reason results in forfeiture of future salary and benefits, as well as forfeiture of the restricted shares of FIC common stock.

In November 2003, Mr. Johnson and his wife, Carol Johnson, filed suit in Harris County, Texas District Court against the Company, FIC Financial Services, Inc. (“FICFS”) and an employee of the Company. The suit, which sought an unspecified amount of damages and injunctive relief, alleges that the defendants interfered with the non-JNT contract and business relationships of the plaintiffs, made slanderous statements regarding the plaintiffs, and accessed computer files at the JNT offices relating to the non-JNT business relationships of the plaintiffs, without the consent of the plaintiffs. The suit also alleged conspiracy, conversion, and various other torts, all related to the defendants’ investigation of plaintiff’s business practices at JNT.

Subsequently, Mr. Johnson filed a demand for arbitration under his employment agreement, which has a mandatory arbitration clause. In the arbitration, Mr. Johnson sought damages for breach of contract and various other benefits relating to the termination of his employment contract, totaling $913,133.40. In connection with the arbitration, FIC submitted a counter-claim, alleging that Mr. Johnson committed multiple breaches of his employment agreement, and that he breached his fiduciary duty to FIC as a result of his actions in conducting the business of JNT, thereby entitling FIC to a dismissal of plaintiff’s claims. Prior to the hearing on the arbitration, the Harris County Court ordered that the matters raised in that lawsuit by Mr. Johnson (though not Carol Johnson) be combined with the arbitration.

An arbitration hearing on Johnson’s contract claims was conducted in April 2005. On July 21, 2005, the Arbitrator issued an interim award in which he denied all of Johnson’s claims for breach of contract, as well as Johnson’s claims with respect to the restricted shares of FIC stock. In denying Johnson’s claims, the Arbitrator concluded that:

(1) Johnson had committed multiple and material breaches of his employment agreement by operating a personal tax and accounting business out of office space and using employees, utilities and other items, all paid for by FICFS; by engaging in a self-dealing transaction involving the payment to himself of $25,000 out of funds held by JNT in a suspense account, an account to which JNT owed fiduciary duties to its customers and clients; and by firing an employee of JNT on the same day that the employee inquired about possible workers compensation benefits in connection with an on-the-job injury,

(2) Johnson’s breaches of his employment agreement occurred prior to the time that he was placed on administrative leave, thereby precluding him from maintaining a breach of contract suit against FIC and FICFS, and

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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED

(Unaudited)

(3) The change in the majority of the Board of Directors of FIC resulting from the 2003 Annual Meeting of FIC’s shareholders did not constitute a “change of control” under Johnson’s employment agreement, thereby denying Johnson’s claim that he was entitled to a “good reason” termination of his employment agreement.

In addition, the Arbitrator awarded FICFS $28,000, plus interest at the rate of 6% per annum from July 21, 2005, to the date of payment, with respect to Johnson’s unauthorized conversion of funds held in the JNT suspense account. The order confirming the arbitration award was signed on February 27, 2006, by the Harris County district judge and the Company is currently pursuing collection of the judgment. No amounts have been recorded in the Company’s financial statements for such judgment.

With respect to the matters raised by Mr. Johnson in the Harris County lawsuit, which were referred by the Court to the arbitration, following his loss in the arbitration of the employment agreement, Mr. Johnson notified the Arbitrator that he would not pursue arbitration of his other claims. In addition, in May 2006, Mrs. Johnson filed a notice of non-suit with respect to the claims made by her in the Harris County lawsuit. Accordingly, this matter is now closed.

Litigation with Equita Financial and Insurance Services of Texas, Inc. and M&W Insurance Services, Inc.

On June 2, 2005, Equita and M&W Insurance Services, Inc. (“M&W”) filed a civil suit in Travis County, Texas District Court against the Company. The suit alleges that, in entering into certain agreements with the plaintiffs, the Company made certain misrepresentations and omissions as to its business and financial condition. The agreements referenced in the suit consist of (a) an option agreement entered into in June 2003 between Equita and the Company, granting Equita the right to purchase shares of FIC’s common stock at $16.42 per share, if certain sales goals were achieved under an exclusive marketing agreement between Equita and a subsidiary of the Company (the “Option Agreement”), (b) a stock purchase agreement entered into in June 2003 between M&W and the Roy F. and Joann Cole Mitte Foundation, pertaining to the purchase of 204,918 shares of FIC’s common stock (the Stock Purchase Agreement”), and (c) a registration rights agreement entered into in June 2003 among the plaintiffs and the Company, whereby the Company agreed to file and maintain a shelf registration statement which respect to the shares of FIC’s common stock purchased by M&W from the Mitte Foundation or which may be acquired in the future by Equita under the option agreement (the “Registration Rights Agreement,” and, collectively, the “Agreements”).

The suit alleges that the Company breached the provisions of the Option Agreement by refusing to indemnify the plaintiffs for losses relating to the alleged breach of certain representations and warranties included in the Option Agreement. The plaintiffs also allege that the Company required M&W to purchased 204,918 shares of FIC common stock from the Mitte Foundation as a condition of Equita’s obtaining, in June 2003, an exclusive marketing agreement with a subsidiary of the Company pertaining to the distribution of insurance products in the “senior market” (the “Marketing Agreement”), and that such requirement was motivated by the desire of the Company’s management to obtain certain proxy rights obtained under a settlement agreement with the Mitte Foundation and the Mitte family. The plaintiffs further allege that the Company breached the provisions of the Registration Rights Agreement by failing to file a shelf registration with the SEC with respect to the shares of FIC’s common stock purchased by M&W from the Mitte Foundation and the shares which may be acquired in the future by Equita under the provisions of the Option Agreement. The plaintiffs seek rescission of the Agreements; damages in an amount equal to the $3 million that M&W paid to acquire FIC shares from the Mitte Foundation, together with interest and attorney’s fees and unspecified expenses; and an unspecified amount of exemplary damages.

Late in 2005, the Company’s two life insurance subsidiaries, Investors Life and Family Life, intervened in the lawsuit to assert claims that Equita had breached its obligations under the Marketing Agreement with respect to the distribution of insurance products, thereby causing damages to the life insurance subsidiaries. Equita moved to dismiss the intervention, but at a hearing on December 20, 2005, the court denied Equita’s motion. As a result, Investors Life and Family Life will be permitted to assert their claims against Equita in this lawsuit.

Deposition discovery with respect to both the case filed by Equita and M&W, and the claims in intervention asserted by Family Life and Investors Life, began in October 2006.

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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED

(Unaudited)

In response to a motion for partial summary judgment, the Company has stipulated to certain elements of some of the causes of action asserted by Equita and M&W, including that certain representations and warranties made in the Option Agreement were partially incorrect, and that FIC was unable to comply with certain of its obligations under the Option Agreement. FIC did not stipulate, and continues to dispute, other elements of certain of the causes of action asserted by Equita and M&W, and disputes other causes of action in their entirety. FIC intends to vigorously oppose the lawsuit and any effort by Equita and M&W to recover damages from FIC, and the life insurance subsidiaries intend to vigorously prosecute their claims in intervention against Equita.

Shareholder Claim

The Company received a demand letter in April 2004 from a law firm representing an individual shareholder (Mr. Cook) who owns 530 shares of the Company’s common stock, which letter set forth certain allegations and notified the Registrant that the shareholder intended to file a shareholder derivative lawsuit (the “Demand Letter”).

In May 2004, FIC, by and through its Special Litigation Committee, filed a petition in the 250th District Court of Travis County, Texas (the “Court”), seeking to have the Court appoint a panel of independent and disinterested persons pursuant to Section H (3) of Article 5.14 of the Texas Business Corporation Act to investigate the allegations, and stay any shareholder derivative actions. Subsequently, on June 1, 2004, the Court issued an Order appointing Eugene Woznicki, Kenneth S. Shifrin, John D. Barnett and F. Gary Valdez as a panel of independent and disinterested persons (the “Panel”) to make determinations contemplated by Section F of Article 5.14 of the Texas Business Corporation Act in connection with the Demand Letter and staying any shareholder derivative actions relating to the letter until the Panel’s review was completed and a determination was made by the panel as to what, if any, further action was to be taken. Messrs. Woznicki, Shifrin and Barnett are independent directors of FIC. Mr. Valdez is neither a director nor an employee of FIC. Mr. Valdez is the founder and president of Focus Strategies, L.L.C. and is active in various community and civic organizations in the Austin, Texas area.

Following an extensive review of the claims made by the individual shareholder, the Panel, in January 2005, filed with the court a Petition for Declaratory Judgment pursuant to the Texas Declaratory Judgments Act and Article 5.14 of the Texas Business Corporations Act (the “Petition”). The Petition describes the process used by the Panel and its counsel in considering the matters raised in the Demand Letter and the submittal provided by counsel for the shareholder. The Petition advised the Court that, after consideration of the evidence obtained through its inquiry, the Panel had unanimously made a good faith determination that the continuation of the Committee’s derivative proceeding and the commencement of any further derivative proceedings based on the allegations made by the individual shareholder was not in the best interests of FIC.

On October 10, 2005, the 250th District Court of Travis County, Texas, heard for trial on the merits the matters raised by the Panel in the Petition (Financial Industries Corporation v. Tom Cook (Cause No. GN 401513). After consideration of the pleadings, evidence and authorities submitted by counsel for the Company, the Court issued a Final Judgment on October 10, 2005, in which it ruled that the determinations made by the Panel, as reflected in a report submitted to the Court by a Special Litigation Committee appointed by the Registrant’s Board of Directors, were made: (1) in good faith, (2) after the Panel conducted a reasonable inquiry, and (3) based on the factors deemed appropriate under the circumstances by the Panel. The Court’s ruling otherwise dismissed with prejudice the derivative proceedings involved in this matter. The Final Judgment was approved as to form and substance by counsel for the Registrant and by counsel for the defendant.  

Management Conclusion on Legal Proceedings

In the opinion of the Company’s management, it is not currently possible to estimate the impact, if any, that the ultimate resolution of these foregoing legal proceedings will have on the Company’s results of operations, financial position, or cash flows.

Other Litigation

FIC and its insurance subsidiaries are regularly involved in litigation, both as a defendant and as a plaintiff. The litigation naming the insurance subsidiaries as defendant ordinarily involves our activities as a provider of insurance products. Management does not believe that any of this other litigation, either individually or in the aggregate, will have a material adverse effect on the Company’s business or financial condition.

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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED

(Unaudited)

8. Subsequent Events

Sale of Family Life Insurance Company

On December 29, 2006, the Company completed the sale of its wholly owned subsidiary, Family Life Insurance Company to The Manhattan Life Insurance Company ("Manhattan Life").  The cash sales price was $28.0 million, subject to certain post closing adjustments as set forth in the definitive agreement dated December 8, 2006.

Prior to the sale, Family Life owned 648,640 shares of FIC common stock. Such shares are reflected as common treasury stock in the accompanying consolidated financial statements. In conjunction with this transaction, the Company acquired from Family Life 324,320 of these shares and the remaining 324,320 shares remained with Family Life at the time of sale. Also, prior to the closing of the sale, the Family Life Pension Plan, along with its assets and liabilities, was transferred from Family Life Insurance Company to its upstream parent company, Family Life Corporation (“FLC”). FLC is wholly owned by FIC and all current and future obligations of the Family Life Pension Plan are the responsibility of FLC.

Also in conjunction with the sale, the Company’s Investors Life subsidiary entered into a coinsurance arrangement with Manhattan Life related to sales of certain future insurance products historically marketed by Family Life, such as traditional mortgage life insurance.

At September 30, 2006, Family Life had assets totaling approximately $121.9 million and capital and surplus totaling approximately $16.3 million, as reported on a statutory basis of accounting for insurance regulatory purposes. The Company has not yet completed the preparation of its 2006 consolidated financial statements as prepared under GAAP. The estimated GAAP equity basis in Family Life, including other adjustments that will affect the determination of loss from the sale, totals approximately $60 million. Accordingly, management estimates that a GAAP loss between $30 million and $35 million will result from this sale. The foregoing amounts are unaudited and could change significantly upon completion of 2006 GAAP financial statements and the audits of such financial statements.

Amendment of Subordinated Loans

FIC and FLC have subordinated notes payable to Investors Life with an unpaid balance of $15.4 million at June 30, 2005 and December 31, 2004. With the approval of the Texas Department of Insurance, the loans were restructured as of March 9, 2006. As amended, the loans provide for a one year moratorium on principal payments for the period from March 12, 2006, to December 12, 2006, with principal payments to resume on March 12, 2007, with ten equal quarterly principal payments until the maturity date of June 12, 2009. These notes have been eliminated in the consolidated financial statements. The Company retired these subordinated notes payable on December 29, 2006 using a portion of the proceeds from the sale of Family Life Insurance Company.

21

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion addresses the financial condition of Financial Industries Corporation (“FIC”) as of June 30, 2005, compared with December 31, 2004, and its results of operations for the three and six month periods ended June 30, 2005, compared with the same period last year. This discussion should be read in conjunction with Management’s Discussion and Analysis included in FIC’s Form 10-K for the year ended December 31, 2004, to which the reader is directed for additional information.

Results of Operations - Three Months Ended June 30, 2005 and 2004

For the three month period ended June 30, 2005, the Company reported net income of $4.7 million and basic and diluted earnings per common share of $0.48 compared to a net loss of $3.8 million and basic and diluted loss per common share of $0.38 for the three month period ended June 30, 2004. The three months ended June 30, 2005 and 2004 include the impact of certain trends and changes in the business of the Company which are dominant in the results of the six months ended June 30, 2005 and 2004. These items are described in the six-month results of operations below. Of these results, certain significant items of change between the three months ended June 30, 2005 and 2004 which result in the significant change in net income between periods are as follows:

· Increase in net realized gains of $9.2 million primarily due to the sale of River Place Pointe;

· Decrease in operating expenses of $1.4 million resulting from the reduction of unusual expenses noted below in the six months ended June 30, 2004;

· Increase in provision for federal income taxes of $2.4 million.

Results of Operations - Six Months Ended June 30, 2005 and 2004

For the six-month period ended June 30, 2005, FIC’s net income was $3.5 million (basic and diluted earnings of $.36 per common share) on revenues of $58.1 million as compared to net loss of $6.1 million (basic and diluted loss of $.62 per common share) on revenues of $53.8 million in the first six months of 2004.

In 2005, FIC’s net income (loss) was affected by the following:

· Decrease in net investment income of $1.9 million primarily due to effects of lower market interest rates and the decline in investments held in fixed maturities, equity securities, or short-term investments from June 30, 2004;

· Increase in net realized gains of $7.4 million primarily due to the sale of River Place Pointe;

· Decrease in policyholder benefits and expenses of $4.4 million resulting from the decline in the amount of death claims and policy surrenders;

· Decrease in operating expenses of $2.6 million resulting from the reduction of unusual expenses in the three months ended June 30, 2005;

· Increase in provision for federal income taxes of $2.8 million.

In 2004, FIC’s net loss was affected by the following:

· Significantly higher policyholder benefits and expenses totaling $24.3 million for the six months ended June 30, 2004, compared to $21.5 million for the same period in 2003. A substantial portion of this increase was related to higher death benefits.

· Effective January 1, 2004, the Company adopted Statement of Position (“SOP”) 03-01, “Accounting and Reporting by Insurance Enterprises for Certain Non-traditional Long-Duration Contracts and for Separate Accounts.” This resulted in recognizing additional income totaling $229,000, net of taxes, as a cumulative effect of change in accounting principle in 2004. The implementation of this SOP changed the pattern of recognition of bonus interest credited to contractholders for certain of the Company’s insurance products.

· Significant auditing, actuarial, accounting, consulting, and legal fees were incurred throughout 2004, much of which was associated with the internal review of the Company’s financial accounts and resulting restatement of prior years’ financial statements as reported in its 2004 Form 10-K filing.

The above described items need to be taken into consideration in drawing comparisons between the operating results for the six months ended June 30, 2005 and 2004.

22

Revenues

Premium revenues reported for traditional life insurance products are recognized when due. Premium income for the first six months of 2005, net of reinsurance ceded, was $12.0 million, as compared to $12.4 million in the first six months of 2004. This source of revenues is related to the traditional life insurance book of business of FIC’s insurance subsidiaries. The decrease in premium income reflects the run-off in the Company’s existing traditional life insurance book of business for both first year and renewal premiums. The decrease in renewal premiums is exceeding first year premium production levels, resulting in the overall decline in premium revenues on traditional life insurance products.

In accordance with GAAP, deposits received by FIC in connection with annuity contracts and premiums received for universal life (“UL”) insurance policies are reflected in FIC’s financial statements as increases in liabilities for contractholder deposit funds and not as revenues. Earned insurance charges assessed against these deposits are reported as revenue. For the six months ended June 30, 2005 and 2004, annuity deposits and UL premiums totaled $17.4 million and $22.9 million, respectively.

The decline in UL premiums and annuity deposits reflects the net run-off of business from the Company’s existing book of business, and declining sales of new UL policies. Although the Company is focusing on reversing these trends on an overall basis, management has de-emphasized the sale of annuity and UL products in periods subsequent to 2003 due primarily to the current interest-rate environment and certain design features of FIC’s current annuity products.

Earned insurance charges totaled $20.3 million for the first six months of 2005, as compared to charges of $20.9 million in the same period of 2004. These revenues primarily consist of UL cost of insurance charges, but also include policy surrender charges, and policy administration charges. The decline in earned insurance charges from 2004 to 2005 is primarily due to reduced UL cost of insurance charges resulting from the net run-off of business.

Net investment income for the first six months of 2005 was $14.7 million as compared to $16.6 million in the same period of 2004. The decrease in net investment income from 2004 to 2005 was primarily attributable to 1) a decline in the income received from the Company’s interest-bearing investments, resulting from decreasing interest rates during 2004 and 2) reduction in total investments in fixed maturities, equity securities, and short-term investments compared to the first six months of 2004.

Real estate income is primarily earned from the leases on the buildings at the Company’s River Place Pointe office complex in Austin, Texas. Real estate income (revenues from leases less associated operating expenses and depreciation) was $547,000 for the six-month period ended June 30, 2005, which is with a slight decline from $842,000 in the same period in 2004. This decline is attributable primarily to additional operating expenses and depreciation of River Place Pointe. In June 2005, the Company sold the River Place Pointe property, and accordingly, the Company will no longer have significant real estate-related income subsequent to June 1, 2005 as the sales proceeds were reinvested primarily in fixed maturity securities.

Net realized investment gains were $9.3 million in the first six months of 2005, as compared to $1.9 million in the first six months of 2004. The realized gains for 2005 were primarily from the sale of River Place Pointe. The office complex was sold in June 2005, in a cash transaction, for $103 million. The Company realized a gain of $10.6 million on the sale, which included both a current realized gain of $8.5 million and a deferred gain of $2.1 million to be recognized as a reduction of office lease expenses over the period from the sale date through March 31, 2008. The realized gains for 2004 were primarily from the sales of fixed maturity securities and one of the Company’s real estate properties classified as held for sale.

Benefits and Expenses

Policyholder benefits and expenses, which consist primarily of death benefit claims, were $19.9 million in the first six months of 2005, as compared to $24.3 million in the first six months of 2004. The decrease in policyholder benefits and expenses was primarily attributable to both lower death benefit claims and surrenders of traditional life insurance policies.

Interest expense on contractholder deposit funds represents interest paid or credited to contractholders on cash values accumulated in their universal life insurance and annuity accounts. Interest expense totaled $11.1 million in the first six months of 2005, as compared to $11.7 million in the same period of the year 2004. The decrease in interest expense in 2005 was primarily attributable to the continued trend of reductions in interest rates credited to policyholders, as the Company managed its interest spread in response to the low and declining interest rates that characterized 2005 and 2004.

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With the decline in market interest rates, there can be effects on the interest spread which is the difference in the Company’s investment portfolio rate and the interest rates credited on policyholder contracts for universal life insurance and annuities. The Company responded to the lower market rates by lowering many of the credited rates on its policies during 2004 and 2005. However, universal life insurance and annuity policies have contractual minimum guaranteed rates and credited rates cannot be lower than such minimums. Because many of the Company’s policies have minimum guaranteed rates of 4.0%, the market interest rate environment in recent years has put pressure on the Company’s interest spread.

Amortization of deferred policy acquisition costs (“DAC”) for the first six months of 2005 was $5.7 million, as compared to $6.1 million in the same period in 2004. These expenses represent the amortization of the costs of producing new business, which consists primarily of agents’ commissions and certain policy issuance and underwriting costs. For traditional life insurance business, DAC is amortized over the estimated premium-paying period of the policies in proportion to annual premium revenue. For interest sensitive products, these costs are amortized in relation to the estimated annual gross profits of the policies. The level of policy lapses and surrenders can also have a significant impact on the amount of amortization in any reporting period.

Present value of future profits of acquired business (“PVFP”) is amortized in a similar manner as DAC, as previously described, for acquired traditional and interest sensitive business. Amortization of PVFP totaled $1.3 million and $1.7 million for the six months ended June 30, 2005 and 2004, respectively. The amortization is consistent with the run-off of the acquired blocks of business.

Operating expenses for the first six months of 2005 were $14.6 million, as compared to $17.1 million in the first six months of 2004. This decrease in the level of operating expenses is primarily the result of several unusual items occurring during the first six months of 2004.

During 2004, the Company took significant steps to reduce the level of operating expenses. Subsequent to the changes in the Board and management in late 2003 and early 2004 a comprehensive review of the Company’s staffing and operational structure was performed. This review identified numerous opportunities in these areas for reductions in the Company’s cost structure, given the current levels of sales and business in force. Accordingly, significant reductions in staffing levels were achieved in late 2003 and during 2004.

Although cost reduction steps were implemented in 2004, with additional steps taken in 2005, these savings were significantly offset by extraordinary auditing, actuarial, accounting and other consulting, and legal expenses associated with the reexamination and restatement of the Company’s 2003 consolidated financial statements, compliance with Sarbanes-Oxley, and with its litigation matters as previously described herein.

Interest expense was $532,000 and $411,000 for the six months ended June 30, 2005 and 2004, respectively. The interest expense relates to debt service on $15 million aggregate principal amount of floating rate Senior Notes due 2033 (the “Senior Notes”). The Senior Notes bear interest quarterly at the three-month LIBOR rate plus 4.2%.

Taxes

The provision for federal income taxes on loss from operations, before cumulative effect of change in accounting principles, reflects a tax provision totaling $1.4 million and a tax benefit totaling $1.4 million for the six months ended June 30, 2005 and 2004, respectively. These tax amounts equate to effective tax provision rate of 28% and tax benefit rate of 18% for the six months ended June 30, 2005 and 2004, respectively. The primary reason for the deviation from the expected statutory tax rate of 34% for the Company is due to increases in the valuation allowance for deferred tax assets. Deferred income tax assets are subject to ongoing evaluation of whether such assets will be realized. Realization of deferred tax assets is dependent upon the Company's generation of sufficient taxable income in the future to recover tax benefits that cannot be recovered from taxes paid in prior periods. If future taxable income is not expected, the Company establishes a valuation allowance, when based on the weight of the available evidence, it is more likely than not that some portion of the deferred tax assets will not be realized. The Company’s deferred tax assets are primarily comprised of net operating losses of FIC and its non-life insurance subsidiaries.

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Change in Accounting Principle

Effective January 1, 2004, the Company adopted Statement of Position (“SOP”) 03-01, “Accounting and Reporting by Insurance Enterprises for Certain Non-traditional Long-Duration Contracts and for Separate Accounts.” This resulted in recognizing additional income totaling $229,000, net of taxes, as a cumulative effect of change in accounting principle for the six months ended June 30, 2004. The implementation of this SOP resulted in a change in the pattern of recognition of bonus interest credited to contractholders for certain of the Company’s insurance products.

Liquidity and Capital Resources

Liquidity describes the ability of a company to generate sufficient cash flows to meet the cash requirements of business operations. FIC is an insurance holding company whose principal assets consist of its insurance subsidiaries - Family Life Insurance Company (“Family Life”) and Investors Life Insurance Company of North America (“Investors Life”). As a holding company, FIC’s ability to pay interest and principal on its debt, pay its expenses, and pay dividends on its common stock depend substantially upon its receipt of dividends or other cash flow from these subsidiaries.

Liquidity management is designed to ensure that adequate funds are available to meet all current and future financial obligations. The Company meets its liquidity requirements primarily by funding cash used in operations with cash flows provided by investing activities. Proper liquidity management is crucial to preserve stable, reliable, and cost-effective sources of cash to meet the future benefit payments under our various insurance and deposit contracts, pay operating expenses (including interest and income taxes), and maintain reserve requirements. In this process, we focus on our assets and liabilities, and the impact of changes in both short-term and long-term interest rates, market liquidity and other factors. We believe we have the ability to generate adequate cash flows to fund obligations as they come due.

At the holding company level, FIC’s principal current ongoing liquidity demands relate to the payment of principal and interest on its indebtedness. As of June 30, 2005, Investors Life held $15.4 million of notes receivable from the Company (the “Affiliated Notes”) with quarterly interest payments at an annual rate of 5%. Although this intercompany indebtedness is eliminated on FIC’s condensed consolidated balance sheets, it creates a debt service requirement at the holding company level.

With the approval of the Texas Department of Insurance, the Affiliated Notes were restructured as of March 9, 2006. As amended, the loans provide for a one year moratorium on principal payments for the period from March 12, 2006, to December 12, 2006, with principal payments to resume on March 12, 2007, with ten equal quarterly principal payments until the maturity date of June 12, 2009. As previously described in Note 8 of the accompanying financial statements, the Company retired the affiliated notes on December 29, 2006, using a portion of the proceeds from the sale of Family Life Insurance Company.

The holding company’s other principal liquidity requirement is debt service on the $15 million of Senior Notes. These notes require quarterly interest payments at a variable interest rate of the three-month LIBOR rate plus 4.2%. The principal amount of the Senior Notes must be repaid in a single payment in 2033.

In addition to these debt service requirements, the holding company must pay its expenses in connection with Board of Directors fees, insurance costs, corporate overhead, certain audit and accounting fees, and legal and consulting expenses as incurred. The holding company has not paid any dividends to its shareholders since early in 2003, and management does not anticipate the payment of such dividends in the near future.

In June 2004, FIC, with the approval of the Texas Department of Insurance, formed a service company subsidiary and transferred to it many of the administrative functions of the insurance companies. The new service company charges each insurance company a monthly service fee that is calculated using a formula based on policies under management, new policies issued, managed assets, and other factors. Profits earned by the service company are paid as dividends to the holding company, providing an additional source of liquidity at the holding company level.

The ability of Family Life and Investors Life to pay dividends to FIC and help meet these holding-company liquidity demands is subject to restrictions set forth in the insurance laws and regulations of Texas, its domiciliary state. Texas limits how and when Family Life and Investors Life can pay such dividends by (a) including the “greater of" standard for payment of dividends to shareholders and (b) requiring that prior notification of a proposed dividend be given to the Texas Department of Insurance. Under the “greater of" standard, an insurer may pay a dividend in an amount equal to the greater of: (i) 10% of the capital and surplus or (ii) the insurer's net gain from operations for the previous year.

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Liquidity considerations at FIC’s insurance subsidiaries are different in nature than for the holding company. Sources of cash for FIC’s insurance subsidiaries consist of premium payments and deposits from policyholders and annuity holders, charges on policies and contracts, investment income, and proceeds from the sale of investment assets. These funds are applied primarily to provide for the payment of claims under insurance and annuity policies, payment of policy withdrawals, surrenders and loans, operating expenses, taxes, investments in portfolio securities, and shareholder dividends.

A primary liquidity consideration with respect to life insurance and annuity products is the risk of early policyholder and contractholder withdrawal. Deposit fund liabilities for universal life and annuity products as of June 30, 2005 were $558.0 million, compared to $572.1 million at December 31, 2004. Individual life insurance policies are less susceptible to withdrawal than are annuity contracts because life insurance policyholders may incur surrender charges and undergo a new underwriting process in order to obtain a new insurance policy. At June 30, 2005, the bulk of the liabilities for contractholder deposit funds on FIC’s condensed consolidated balance sheet, $416.6 million, represented insurance products, as compared to $141.4 million of annuity product liabilities.

Since each insurance company holds large portfolios of highly liquid publicly traded debt securities, raising cash through asset sales is available should other sources of liquidity fail to provide cash as needed. In this regard, however, the insurance companies must be concerned about such sales at inopportune times, when adverse movements in interest rates may have depressed the market price of securities so that sales would result in the realization of significant losses. To guard against such an outcome, FIC’s management monitors benefits paid and surrenders of insurance products to provide projections of future cash requirements. Also as part of this monitoring process, FIC performs cash flow testing of assets and liabilities at each year-end to evaluate the match between the planned maturities of the insurance company assets and the likely liquidity needs of the companies over time. Such cash-flow testing, prescribed by insurance laws and regulations, models the likely performance of assets and liabilities over time, using a wide variety of future interest rate scenarios.

There can be no assurance that future experience regarding benefits and surrenders will be similar to the historic experience on which such cash-flow testing is based, since withdrawal and surrender levels are influenced by such factors as the interest-rate environment and general economic conditions as well as the claims-paying and financial strength ratings of FIC’s insurance subsidiaries.

Cash and cash equivalents at June 30, 2005 were $53.7 million compared to $52.0 million at December 31, 2004. The $1.7 million increase in cash and cash equivalents at June 30, 2005 from December 31, 2004 was due primarily to proceeds from the sales of invested real estate, net of reinvestment of much of the proceeds in fixed maturity securities and short-term investments. This was partially offset by the net payout of contractholder deposits and use of cash by operations.

Net cash used in operating activities was $4.4 million for the six month period ended June 30, 2005, compared to $8.6 million used in operating activities for the same period of 2004. The decrease in cash used in operating activities of $4.4 million from 2004 to 2005 was primarily attributable to decreases in other receivables primarily due to federal income taxes recoverable and increases in deferred federal income taxes.

Net cash provided by investing activities was $22.5 million in the six month period ended June 30, 2005, compared to net cash used in investing activities of $24.5 million for the same period of 2004. The $47 million increase in cash provided by investing activities in 2004 from 2005 was due primarily to proceeds received from the sale of River Place Pointe, offset by reinvestment of these proceeds into fixed maturity securities available for sale and short-term investments.

Net cash used in financing activities was $16.4 million in the first six months of 2005, compared to $11.6 million used in the first six months of 2004. The increase in cash used in financing activities of $4.8 million is attributable to contractholder fund deposits and withdrawals for annuity and universal life insurance policies. For the six months ended June 30, 2005 and 2004, contractholder fund withdrawals exceeded deposits by $16.4 million and $11.6 million respectively. The change in net withdrawals in 2005 is due to a decline in deposits in 2005 from 2004 of $5.5 million and a decrease in withdrawals of $.7 million for the same period.

In light of the information and considerations outlined above, management believes at this time that the liquidity of FIC and its subsidiaries is sufficient to meet the needs of its business, including its debt service requirements.

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Financial Condition

During the six months ended June 30, 2005, the equity of the shareholders of the Company (that is, the excess of the Company’s assets over its liabilities) increased by $5.9 million. The primary changes resulting in the increase to shareholders’ equity are detailed as follows:

· Net income for the six months of $3.5 million

· $2.3 million reduction in accumulated other comprehensive loss from change in net unrealized losses on investments in fixed maturity and equity securities available for sale

Assets

In 2003, following a review of the investment portfolios of the life insurance subsidiaries of the Company and the poor performance of recent reinvestments by the former management, the Investment Committee of the Company's then newly elected Board of Directors recommended the engagement of a third-party investment manager to provide ongoing, professional management of the portfolios. In October 2003, the life insurance subsidiaries entered into investment management agreements with Conning. Under these agreements, Conning manages the investment security portfolios of the Company’s life insurance subsidiaries in accordance with investment policies set by the Company’s Board of Directors.

The Company, working with Conning, also revised the investment policies of its insurance subsidiaries. The new policies reiterate compliance with legal requirements of state insurance laws and regulations that are applicable to the Company’s insurance company subsidiaries. They also emphasize sensitivity to the way that FIC’s liabilities are likely to change over time and with changes in general interest rate levels. In practical terms, this means that the Company now focuses almost all of its investment in investment-grade securities, keeping the schedule of anticipated asset maturities in line with its projected cash needs. It also means that the Company attempts to keep the duration of its investment assets (a measure of the sensitivity of their value to changes in interest rates) in line with the duration of the Company’s liabilities.

Since the engagement of Conning as the Company’s investment manager, the Company has realigned its portfolio, decreasing its investment in mortgage-backed securities (including asset-backed securities) significantly, from 37.4% at December 31, 2004 to 31.2% at June 30, 2005, expressed as a percentage of its total investment in fixed maturities. Such securities are sensitive to changes in prevailing interest rates, since interest rate levels affect the rate at which the underlying mortgage obligations are repaid. FIC’s insurance subsidiaries have reduced the risk of prepayment associated with mortgage-backed securities by investing in planned amortization class (“PAC”), target amortization class (“TAC”) instruments and scheduled bonds. These investments are designed to amortize in a predictable manner by shifting the risk of prepayment of the underlying collateral to other investors in other tranches (“support classes”) of the CMO.

FIC’s equity securities consist primarily of its investment in the investment funds underlying the separate accounts business of Investors Life Insurance Company of North America (“Investors Life”). However, during 2005, the Company increased its equity security holdings by investing $2.1 million in a corporate bond mutual fund as part of a strategy to increase diversification and enhance overall investment performance. As of June 30, 2005, the market value of FIC’s equity securities was $10.4 million, compared to $8.5 million at December 31, 2004.

FIC’s real estate investment is primarily related to the River Place Pointe office complex (“River Place Pointe”) owned by Investors Life. At December 31, 2004, FIC’s investment totaled $90.1 million in this 600,000 sq. ft., seven-building office complex on 48 acres in Austin, Texas. FIC and its insurance company subsidiaries occupy one of the seven buildings. The project was sold in June 2005, in a cash transaction, for $103 million. The Company realized a gain of $10.6 million on the sale, which included both a current realized gain of $8.5 million and a deferred gain of $2.1 million to be recognized over the period from the sale date through March 31, 2008.

Investors Life had $349.4 million of separate account assets as of June 30, 2005 (not including the value of the Company’s own investment in one of the accounts), as compared to $359.9 million at the end of 2004. These assets include (a) two variable annuity separate accounts that permit contractholders to allocate their contract values among a selection of third-party mutual funds and (b) assets held in custodian accounts in connection with investment annuity contracts. The investment annuity business is reinsured with Symetra Life Insurance Company (formerly Safeco Life Insurance Company), a third-party reinsurer, on a 90%/10% coinsurance basis, with Investors Life retaining 10% of such business. Since the reinsurance treaty is on a coinsurance basis, Investors Life is contingently liable to the policyholders in the event that the reinsurer is unable to fulfill its obligations under the treaty. Investors Life is not marketing new separate account annuity contracts.

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Effective June 1, 2006, Investors Life recaptured the previously reinsured investment annuity business with Symetra Life resulting in the retention of 100% of this business. The Company expects the recapture of this previously reinsured business to increase revenues in 2006 and future years. However, as this is a closed block of business, the revenues are expected to decrease as the policies in force decline.

Liabilities

The Company’s insurance-related liabilities (future policy benefits and contractholder deposit funds) were $715.4 million at June 30, 2005, compared to $732.3 million at December 31, 2004. The decrease in these insurance-related liabilities reflects the business run-off as previously described.

During the six months ended June 30, 2005, deferred income taxes have increased $2.6 million from December 31, 2004. The change is most notably due to the tax effect of the current year operating results on the net operating loss position of the Company, the change in unrealized losses on fixed maturities available for sale and the change in valuation allowance based on the future realization of the deferred tax assets. This valuation allowance decreased primarily due to the net income of the Company resulting in more recoverable deferred tax assets.

Capital Adequacy

Financial intermediaries such as FIC depend on their equity capital to absorb short-term fluctuations in asset and liability values in their financial structures. They also count on equity capital to support the growth of the business. One typical measure of the strength of a financial holding company such as FIC is the simple ratio of its shareholders’ equity to its total assets. For FIC this ratio was 7.7% at June 30, 2005, compared to 7.1% at December 31, 2004. If separate account assets were not included (which management believes is appropriate) this ratio would have been higher by 3.1% and 2.9% at June 30, 2005 and December 31, 2004, respectively, Management believes that its current equity capital is sufficient to meet the Company’s current liabilities and to fund growth at currently planned levels.

FIC’s insurance subsidiaries are subject to regulation under state law. Among other requirements, these state laws and regulations impose capital adequacy requirements on insurance companies. Using a calculation that takes into account the quality, liquidity, maturities, and amounts of its assets and liabilities, each insurance company is required to calculate its “risk-based capital” (or “RBC”). Total adjusted capital must exceed 200% of the authorized control level RBC to avoid supervisory activity by the insurance regulators. As of December 31, 2005, the total adjusted capital of FIC’s insurance subsidiaries, Family Life and Investors Life, was approximately 717% and 560% of its authorized control level risk-based capital, respectively. The RBC ratio of Investors Life improved as a result of the June 2005 sale of the River Place Pointe real estate investment.

State regulators also use NAIC IRIS ratios to monitor capital adequacy requirements. The NAIC ratios cover 12 categories of financial data with defined “usual” ranges for each such category. The ratios are intended to provide insurance regulators with “early warnings” as to when a company might warrant special attention. An insurance company may fall outside of the usual range for one or more ratios, and such variances may result from specific transactions that are, by themselves, immaterial or eliminated at the consolidation level. In certain states, insurers with more than three IRIS ratios outside of the NAIC usual ranges may be subject to increased regulatory oversight. For 2004, each of the Company’s insurance subsidiaries had six IRIS ratios outside of the usual ranges. However, for 2005 Family Life had five ratios and Investors Life had two ratios which were outside the usual ranges. For Family Life, the ratios outside the usual ranges were primarily related to changes in capital and surplus, net income, investment income, and non-admitted assets. For Investors Life, the ratios outside the usual ranges were primarily related to investment income and changes in premium.

Critical Accounting Policies

The accounting policies below have been identified as critical to the understanding of the results of operations and financial position. The application of these critical accounting policies in preparing the financial statements requires management to use significant judgments and estimates concerning future results or other developments, including the likelihood, timing or amount of one or more future transactions. Actual results may differ from these estimates under different assumptions or conditions. On an ongoing basis, estimates, assumptions and judgments are evaluated based on historical experience and various other information believed to be reasonable under the circumstances. For a detailed discussion of other significant accounting policies, see Note 1 - Organization and Summary of Significant Accounting Policies in the Notes to Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

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Accounting for Premiums on Universal Life Policies and for Annuity Deposits

In accordance with accounting principles generally accepted in the United States of America (“GAAP”), universal life insurance premiums and annuity deposits received are reflected in FIC’s consolidated financial statements as increases in liabilities for contractholder deposit funds and not as revenues. Instead, revenues from such contracts consist of amounts assessed against policyholder account balances for mortality, policy administration and surrender charges, and are recognized in the period in which the benefits and services are provided. Similarly, surrender benefits paid relating to universal life insurance policies and annuities are reflected as decreases in liabilities for contractholder deposit funds and not as expenses.

Investments

The Company’s principal investments are in fixed maturity securities and real estate; all of which are exposed to three primary sources of investment risk: credit, interest rate and liquidity. The fixed maturity securities, which are all classified as available for sale, are carried at their fair value in the Company’s balance sheet, with unrealized gains or losses recorded in accumulated other comprehensive income. The investment portfolio is monitored regularly to ensure that investments which may be other than temporarily impaired are identified in a timely fashion and properly valued, and that impairments are charged against earnings as realized investment losses. The valuation of the investment portfolio involves a variety of assumptions and estimates, especially for investments that are not actively traded. Fair values are obtained from a variety of external sources. The Company has a policy and process in place to identify securities that could potentially have an impairment that is other-than-temporary. This process involves monitoring market events that could impact issuers’ credit ratings, business climate, management changes, litigation and government actions, and other similar factors. This process also involves monitoring late payments, downgrades by rating agencies, key financial ratios, financial statements, revenue forecasts and cash flow projections as indicators of credit issues. At the end of each quarter, all securities are reviewed where fair value is less than ninety percent of amortized cost for six months or more to determine whether impairments should be recorded. The analysis focuses on each issuer’s ability to service its debts and the length of time the security has been trading below cost. This quarterly process includes an assessment of the credit quality of each investment in the entire securities portfolio. The Company considers relevant facts and circumstances in evaluating whether the impairment of a security is other-than-temporary. Relevant facts and circumstances considered include (1) the length of time the fair value has been below cost, (2) the financial position of the issuer, including the current and future impact of any specific events, and (3) the Company’s ability and intent to hold the security to maturity or until it recovers in value. To the extent the Company determines that a security is deemed to be other than temporarily impaired, the difference between amortized cost and fair value is charged to income as a realized investment loss. There are a number of significant risks and uncertainties inherent in the process of monitoring impairments and determining if an impairment is other-than-temporary. These risks and uncertainties include (1) the risk that the Company’s assessment of an issuer’s ability to meet all of its contractual obligations will change based on changes in the credit characteristics of that issuer, (2) the risk that the economic outlook will be worse than expected or have more of an impact on the issuer than anticipated, (3) the risk that fraudulent information could be provided to the Company’s investment professionals who determine the fair value estimates and other-than-temporary impairments, and (4) the risk that new information obtained by the Company or changes in other facts and circumstances lead the Company to change its intent to hold the security to maturity or until it recovers in value. Any of these situations could result in a charge to income in a future period.

Real Estate

The Company monitors the performance of its real estate properties on an ongoing basis and identifies properties it intends to hold for investment and properties it intends to sell. Properties held for investment are classified as investment real estate and are stated at cost less accumulated depreciation. Depreciation is provided using straight-line methods over estimated useful lives of 5 to 40 years, or for leasehold improvements the minimum lease term if shorter. Real estate income is reported net of expenses incurred to operate the properties and depreciation expenses. The Company reviews its investment real estate properties on an on-going basis for impairment using a probability-weighted estimation of the expected net undiscounted future cash flows. If the expected net undiscounted future cash flows are less than the net book value of the property, the excess of the net book value over the Company’s estimate of fair value of the asset is recognized as a realized loss in the consolidated statement of operations and the new cost basis is depreciated over the property’s remaining life.

Properties that are identified for sale and actively marketed by the Company are classified as real estate held for sale and are stated at the lower of cost less accumulated depreciation or net realizable value. No depreciation is recorded while the property is classified as held for sale. Net realizable value is determined by the Company based on the estimated selling price less direct costs of the sale.

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Deferred Policy Acquisition Costs and Present Value of Future Profits of Acquired Business

The costs of acquiring new business, including certain costs of issuing policies and certain other variable selling expenses (principally commissions), are included in deferred policy acquisition costs (“DAC”). DAC is capitalized and then amortized to reflect an appropriate expense in relation to the projected stream of profits (for universal life and annuity products) or to the premium revenue stream (for traditional life products). Similarly, when existing blocks of business are acquired, an intangible capital asset (termed “present value of future profits of acquired business” or “PVFP”) reflecting the costs of acquiring the business is created and then amortized relative to the expected revenues and profitability of the block.

Projections used to determine the rate of amortization of DAC and PVFP require extensive assumptions about, among other things, interest margins, product loads, mortality rates, persistency rates, and maintenance expense levels. In setting the levels of DAC and PVFP amortization, important assumptions must also be made about the appropriate level at which blocks of policies will be aggregated for testing the acceptability of amortization schedules, and views vary widely on this topic. These assumptions involve judgment and are compared to actual experience on an ongoing basis. Significant changes in these assumptions can impact the carrying balance of DAC and PVFP and produce changes that must be reflected in the current period’s income as an unlocking adjustment. Loss recognition is evaluated periodically on an aggregate basis that combines deferred policy acquisition costs with the present value of future profits on acquired business.

Future Policy Benefits

FIC’s liability for future policy benefits accounted for 13.9% of its total liabilities at June 30, 2005, or 20.2% after excluding liabilities associated with separate accounts. These liabilities for future policy benefits, referred to as reserves, are estimated using actuarial methods based on assumptions about future receipts of premiums, interest yields, investment returns, expenses, mortality, morbidity, and persistency. These assumptions consider Company experience and industry standards. The assumptions vary by plan, age at issue, year of issue, and duration. They include estimates, shaped by judgment and experience, and have a substantial impact on the reported financial condition of the Company. Differences between actual experience and assumptions used in the pricing of these policies and in the establishment of liabilities may result in variability of future results in amounts which may be material.

Deferred Taxes

The Company computes deferred income taxes utilizing the asset and liability method. Under this method, balance sheet amounts for deferred income taxes are computed based on the tax effect of the differences between the financial reporting and federal income tax bases of assets and liabilities using the tax rates which are expected to be in effect when these differences are anticipated to reverse. Deferred income tax assets are subject to ongoing evaluation of whether such assets will be realized. Realization of deferred tax assets is dependent upon the Company's generation of sufficient taxable income in the future to recover tax benefits that cannot be recovered from taxes paid in prior periods. The Company establishes a valuation allowance, when based on the weight of the available evidence, it is more likely than not that some portion of the deferred tax assets will not be realized.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

General

FIC’s principal assets are financial instruments, which are subject to market risks. Market risk is the risk of loss arising from adverse changes in market rates, principally interest yields on fixed rate investments. For a discussion of the Company’s investment portfolio and the management of that portfolio to reflect the nature of the underlying insurance obligations of the Company’s insurance subsidiaries, please refer to the information set forth in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

The following is a discussion of the Company’s primary market-risk-sensitive instruments. It should be noted that this discussion has been developed using estimates and assumptions. Actual results may differ materially from those described below. Further, the following discussion does not take into account actions that could be taken by management in response to the assumed changes in market rates. In addition, the discussion does not take into account other types of risks that may be involved in the business operations of the Company, such as the reinsurance recoveries on reinsurance treaties with third party insurers.

The primary market risk to the Company’s investment portfolio is interest rate risk. The Company does not use derivative financial instruments.

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Interest-Rate Risk

The Company manages the interest-rate risk inherent in its fixed maturity assets relative to the interest-rate risk inherent in its liabilities. Generally, we manage interest-rate risk based on the application of a commonly used model. The model projects the impact of interest rate changes on a range of factors, including duration and potential prepayment. For example, assuming an immediate increase of 100 basis points in interest rates, the net hypothetical loss in fair market value related to the financial instruments included in the Company’s condensed consolidated balance sheets is estimated to be $28.3 million at June 30, 2005 and $28.1 million at December 31, 2004. For purposes of the foregoing estimate, fixed maturity securities available for sale, and held for trading, and short-term investments were taken into account. The fair value of such assets was $643.2 million at June 30, 2005 and $562.7 million at December 31, 2004.

The fixed income investments of the Company include certain mortgage-backed securities (excluding asset backed securities). The market value of such securities was $166.7 million at June 30, 2005 and $179.1 million at December 31, 2004. Assuming an immediate increase of 100 basis points in interest rates, the net hypothetical loss in the fair value related to such mortgage-backed securities is estimated to be $10.6 million at June 30, 2005 and $14.1 million at December 31, 2004.

Separate account assets have not been included, since gains and losses on those assets generally accrue to the policyholders.

The Company generally does not use derivative financial instruments to manage its exposure to fluctuations in interest rates.

ITEM 4. CONTROLS AND PROCEDURES

The Company’s disclosure controls and procedures, as defined in Rule 13a-15(e) or 15d-15(e) of the Exchange Act, are designed to ensure that information required to be disclosed in its reports filed with the SEC is recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms, and that such information is accumulated and communicated to its management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely discussions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives and are subject to certain limitations, including the exercise of judgment by individuals, the inability to identify unlikely future events, and the inability to eliminate misconduct completely. As a result, there can be no assurance that the Company’s disclosure controls and procedures will prevent all errors or fraud or ensure that all material information will be made known to management in a timely fashion.

Management has completed an evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934, as amended. This evaluation has allowed management to make conclusions, as set forth below, regarding the state of the Company’s disclosure controls and procedures as of June 30, 2005. Based on its evaluation and the identification of material weakness in internal control over financial reporting described below, and because of an inability to file the Quarterly Report on Form 10-Q within the statutory time period, FIC’s Chief Executive Officer and Chief Financial Officer have concluded that, as of June 30, 2005, FIC’s disclosure controls and procedures were ineffective.

Management had assessed our internal control over financial reporting as of December 31, 2004, the end of our most recent fiscal year. Management based its assessment on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. As disclosed in the Company’s Annual Report on Form 10−K for the fiscal year ended December 31, 2004, in performing its assessment of internal control over financial reporting, management determined that material weaknesses existed in the Company’s internal controls relating to the following areas: control environment, risk assessment, control monitoring, financial close and reporting, segregation of duties, reconciliations, use of third-party service providers, safeguarding of assets, reinsurance, and policy data integrity.

Following its identification of the above-described internal control weaknesses, the Company has been actively engaged in the implementation of remediation efforts to address the material weaknesses in its internal control over financial reporting as of June 30, 2005. There have been no significant changes in the Company’s internal controls or in other factors that could significantly affect internal controls subsequent to the date of the evaluation referred to in this Item.

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PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

The Company and its subsidiaries are defendants in certain legal actions related to the normal business operations of the Company. Management believes that the resolution of such legal actions will not have a material impact on the condensed consolidated financial statements.

T. David Porter v. Financial Industries Corporation

On May 31, 2006, T. David Porter, an FIC shareholder, filed a civil suit in Travis County, Texas District Court (the “Court”), against the Company, seeking to compel the Company to hold an annual meeting of shareholders. FIC has been unable to hold an annual meeting at which its shareholders could be fully informed, or which could be attended by a substantial portion of its shareholders, because the Company is currently unable to comply with Rule 14a-3 of the Securities Exchange Act of 1934, and thus cannot provide an annual report to shareholders or solicit proxies in connection with an annual meeting. Mr. Porter sued under Article 2.24(B) of the Texas Business Corporation Act, which provides that if an annual meeting of shareholders is not held within any 13-month period and a written consent of shareholders has not been executed instead of a meeting, any court of competent jurisdiction in the county in which the principal office of the corporation is located may, on the application of any shareholder, summarily order a meeting to be held. On August 7, 2006, the Company entered into an Agreed Order On Plaintiff’s Motion to Compel Annual Shareholders Meeting (the “Order”) and agreed among other things to hold an annual shareholders meeting for the election of directors on December 6, 2006. The Company did in fact appear for a meeting of shareholders on December 6, 2006, as required by the Agreed Order. In advance of the meeting date, a group affiliated with Mr. Porter solicited proxies from FIC shareholders in an effort to replace FIC’s Board of Directors; the Company remained unable to solicit proxies. However, on the appointed day for the shareholder meeting - December 6, 2006 - a quorum was not in attendance. On December 12, 2006, FIC filed a Motion for Summary Judgment seeking dismissal of Porter’s suit on the grounds that the Agreed Order did not dispense with the requirement of a quorum; the lack of a quorum was a direct and foreseeable result of Mr. Porter’s insistence on a one-sided solicitation and election; FIC has complied with its obligations under the Agreed Order and Mr. Porter has obtained all relief sought by his petition. FIC’s Motion for Summary Judgment remains pending and has not been heard. Mr. Porter thereafter applied for a temporary restraining order and temporary injunction requiring the Company to convene one or more additional meetings of shareholders, contending that in the absence of a quorum on December 6, Texas law and the Company’s bylaws entitled a majority of the shareholders in attendance to choose a date to which the meeting would be adjourned. The District Court held a hearing on Porter’s application, and on December 22, 2006 entered an order providing among other things that FIC will hold an annual shareholders meeting for the election of directors on January 16, 2007 at 10:00 a.m., but that if a quorum is not present on that date, FIC will not be required to hold an annual meeting of shareholders at any time before July 17, 2007. In compliance with the December 22, 2006 order, FIC has mailed new notices of the January 16, 2007 meeting to all shareholders of record as of the October 24, 2006 Record Date.

Litigation with Otter Creek Partnership I, L.P.

During 2003, Otter Creek Management Inc., (“Otter Creek Management”), solicited proxies for the Company’s 2003 Annual Meeting of Stockholders (the “2003 Annual Meeting”) held on July 31, 2003, seeking the election of seven nominees to the Board of Directors of the Company in opposition to the ten candidates selected by the then incumbent Board of Directors. Otter Creek Management is an investment advisory firm that manages three investment funds that are shareholders of the Company: Otter Creek Partners I, LP (“Otter Creek Partners”), Otter Creek International Ltd. and HHMI XIII, LLC (together with Otter Creek Management and Otter Creek Partners, “Otter Creek”).

In connection with this solicitation of proxies, on June 13, 2003, Otter Creek Partners commenced a lawsuit in the District Court in Travis County, Texas, Cause No. GN302872 (the “Litigation”) seeking, among other things, to compel the Company to hold the previously delayed 2003 Annual Meeting. Otter Creek also sought in the Litigation to neutralize the effect of a proxy obtained by the Company from the Mitte Family (the “Mitte Proxy”) the preceding month whereby the incumbent board was able to vote 1,627,610 shares in favor of its nominees.

Following the initiation of this litigation and a hearing before the court, the court ordered the Company not to amend its bylaws in a manner that would adversely affect voting or other matters relating to the Annual Meeting and election of directors and not to reschedule such Annual Meeting scheduled for July 31, 2003, or the record date of the Annual Meeting.

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At the meeting, six of the seven Otter Creek nominees were elected to the Board: R. Keith Long, J. Bruce Boisture, Salvador Diaz-Verson Jr., Patrick E. Falconio, Richard H. Gudeman and Lonnie L. Steffen. The shares covered by the Mitte Proxy were all voted in favor of the incumbent nominees at the 2003 Annual Meeting. Had Otter Creek been successful in neutralizing the effect of the Mitte Proxy, all seven of the Otter Creek nominees would have been elected.

Following the 2003 Annual Meeting, Otter Creek and FIC completed a settlement with respect to the lawsuit in December 2003. Under the settlement agreement, the Company reimbursed Otter Creek for $250,000 in proxy expenses in 2003. An additional $475,000 of proxy and litigation expenses payable in FIC common stock will be submitted to the Company’s shareholders for approval at the next Annual Meeting of Shareholders. If payment of the additional $475,000 is so approved, the amount will be expensed by the Company in the year of approval. The Board of Directors will recommend that shareholders approve the reimbursement. The settlement also included mutual releases between the Company and Otter Creek and its affiliates. The Chairman of the Board of Directors of the Company, R. Keith Long, is the President and owner of the General Partner of Otter Creek Partners I, L.P.

Litigation with Former Employee of Subsidiary

In October 2003, the Company placed Earl Johnson, the then-president of JNT Group, Inc. (“JNT”), a subsidiary of FIC that was later sold in December 2003 in the sale of the New Era companies, on administrative leave pending an investigation of matters related to (1) Johnson’s alleged termination of an employee in response to her request for information regarding her workers’ compensation rights arising out of an injury and (2) his co-mingled and disorganized bookkeeping of JNT’s client accounts with those of a personal business owned by Mr. Johnson and run by him at the same office (using the Company’s employees to do so). Soon after being interviewed in the course of that investigation, Mr. Johnson resigned, alleging good reason under his employment agreement with a subsidiary of FIC, on the ground that the change in the composition of the Board of Directors of FIC following the 2003 Annual Meeting of Shareholders resulted in a “change of control” under the provisions of his employment agreement. The employment agreement provided that if Mr. Johnson were to voluntarily terminate his employment for good reason, he would receive compensation and benefits for the remainder of the three-year term of the agreement and would become fully vested in 17,899 restricted shares of FIC stock. The Company notified Mr. Johnson that his resignation was not for “good reason” pursuant to his employment agreement. Under that agreement, termination without good reason results in forfeiture of future salary and benefits, as well as forfeiture of the restricted shares of FIC common stock.

In November 2003, Mr. Johnson and his wife, Carol Johnson, filed suit in Harris County, Texas District Court against the Company, FIC Financial Services, Inc. (“FICFS”) and an employee of the Company. The suit, which sought an unspecified amount of damages and injunctive relief, alleges that the defendants interfered with the non-JNT contract and business relationships of the plaintiffs, made slanderous statements regarding the plaintiffs, and accessed computer files at the JNT offices relating to the non-JNT business relationships of the plaintiffs, without the consent of the plaintiffs. The suit also alleged conspiracy, conversion, and various other torts, all related to the defendants’ investigation of plaintiff’s business practices at JNT.

Subsequently, Mr. Johnson filed a demand for arbitration under his employment agreement, which has a mandatory arbitration clause. In the arbitration, Mr. Johnson sought damages for breach of contract and various other benefits relating to the termination of his employment contract, totaling $913,133.40. In connection with the arbitration, FIC submitted a counter-claim, alleging that Mr. Johnson committed multiple breaches of his employment agreement, and that he breached his fiduciary duty to FIC as a result of his actions in conducting the business of JNT, thereby entitling FIC to a dismissal of plaintiff’s claims. Prior to the hearing on the arbitration, the Harris County Court ordered that the matters raised in that lawsuit by Mr. Johnson (though not Carol Johnson) be combined with the arbitration.

An arbitration hearing on Johnson’s contract claims was conducted in April 2005. On July 21, 2005, the Arbitrator issued an interim award in which he denied all of Johnson’s claims for breach of contract, as well as Johnson’s claims with respect to the restricted shares of FIC stock. In denying Johnson’s claims, the Arbitrator concluded that:

(1) Johnson had committed multiple and material breaches of his employment agreement by operating a personal tax and accounting business out of office space and using employees, utilities and other items, all paid for by FICFS; by engaging in a self-dealing transaction involving the payment to himself of $25,000 out of funds held by JNT in a suspense account, an account to which JNT owed fiduciary duties to its customers and clients; and by firing an employee of JNT on the same day that the employee inquired about possible workers compensation benefits in connection with an on-the-job injury,

(2) Johnson’s breaches of his employment agreement occurred prior to the time that he was placed on administrative leave, thereby precluding him from maintaining a breach of contract suit against FIC and FICFS, and

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(3) The change in the majority of the Board of Directors of FIC resulting from the 2003 Annual Meeting of FIC’s shareholders did not constitute a “change of control” under Johnson’s employment agreement, thereby denying Johnson’s claim that he was entitled to a “good reason” termination of his employment agreement.

In addition, the Arbitrator awarded FICFS $28,000, plus interest at the rate of 6% per annum from July 21, 2005, to the date of payment, with respect to Johnson’s unauthorized conversion of funds held in the JNT suspense account. The order confirming the arbitration award was signed on February 27, 2006, by the Harris County district judge and the Company is currently pursuing collection of the judgment. No amounts have been recorded in the Company’s financial statements for such judgment.

With respect to the matters raised by Mr. Johnson in the Harris County lawsuit, which were referred by the Court to the arbitration, following his loss in the arbitration of the employment agreement, Mr. Johnson notified the Arbitrator that he would not pursue arbitration of his other claims. In addition, in May 2006, Mrs. Johnson filed a notice of non-suit with respect to the claims made by her in the Harris County lawsuit. Accordingly, this matter is now closed.

Litigation with Equita Financial and Insurance Services of Texas, Inc. and M&W Insurance Services, Inc.

On June 2, 2005, Equita and M&W Insurance Services, Inc. (“M&W”) filed a civil suit in Travis County, Texas District Court against the Company. The suit alleges that, in entering into certain agreements with the plaintiffs, the Company made certain misrepresentations and omissions as to its business and financial condition. The agreements referenced in the suit consist of (a) an option agreement entered into in June 2003 between Equita and the Company, granting Equita the right to purchase shares of FIC’s common stock at $16.42 per share, if certain sales goals were achieved under an exclusive marketing agreement between Equita and a subsidiary of the Company (the “Option Agreement”), (b) a stock purchase agreement entered into in June 2003 between M&W and the Roy F. and Joann Cole Mitte Foundation, pertaining to the purchase of 204,918 shares of FIC’s common stock (the Stock Purchase Agreement”), and (c) a registration rights agreement entered into in June 2003 among the plaintiffs and the Company, whereby the Company agreed to file and maintain a shelf registration statement which respect to the shares of FIC’s common stock purchased by M&W from the Mitte Foundation or which may be acquired in the future by Equita under the option agreement (the “Registration Rights Agreement,” and, collectively, the “Agreements”).

The suit alleges that the Company breached the provisions of the Option Agreement by refusing to indemnify the plaintiffs for losses relating to the alleged breach of certain representations and warranties included in the Option Agreement. The plaintiffs also allege that the Company required M&W to purchased 204,918 shares of FIC common stock from the Mitte Foundation as a condition of Equita’s obtaining, in June 2003, an exclusive marketing agreement with a subsidiary of the Company pertaining to the distribution of insurance products in the “senior market” (the “Marketing Agreement”), and that such requirement was motivated by the desire of the Company’s management to obtain certain proxy rights obtained under a settlement agreement with the Mitte Foundation and the Mitte family. The plaintiffs further allege that the Company breached the provisions of the Registration Rights Agreement by failing to file a shelf registration with the SEC with respect to the shares of FIC’s common stock purchased by M&W from the Mitte Foundation and the shares which may be acquired in the future by Equita under the provisions of the Option Agreement. The plaintiffs seek rescission of the Agreements; damages in an amount equal to the $3 million that M&W paid to acquire FIC shares from the Mitte Foundation, together with interest and attorney’s fees and unspecified expenses; and an unspecified amount of exemplary damages.

Late in 2005, the Company’s two life insurance subsidiaries, Investors Life and Family Life, intervened in the lawsuit to assert claims that Equita had breached its obligations under the Marketing Agreement with respect to the distribution of insurance products, thereby causing damages to the life insurance subsidiaries. Equita moved to dismiss the intervention, but at a hearing on December 20, 2005, the court denied Equita’s motion. As a result, Investors Life and Family Life will be permitted to assert their claims against Equita in this lawsuit.

Deposition discovery with respect to both the case filed by the Equita and M&W, and the claims in intervention asserted by Family Life and Investors Life, began in October of 2006.

In response to a motion for partial summary judgment, the Company has stipulated to certain elements of some of the causes of action asserted by Equita and M&W, including that certain representations and warranties made in the Option Agreement were partially incorrect, and that FIC was unable to comply with certain of its obligations under the Option Agreement. FIC did not stipulate, and continues to dispute other elements of certain of the causes of action asserted by Equita and M&W, and disputes other causes of action in their entirety. FIC intends to vigorously oppose the lawsuit and any effort by Equita and M&W to recover damages from FIC, and the life insurance subsidiaries intend to vigorously prosecute their claims in intervention against Equita.

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Shareholder Claim

The Company received a demand letter in April 2004 from a law firm representing an individual shareholder (Mr. Cook) who owns 530 shares of the Company’s common stock, which letter set forth certain allegations and notified the Registrant that the shareholder intended to file a shareholder derivative lawsuit (the “Demand Letter”).

In May 2004, FIC, by and through its Special Litigation Committee, filed a petition in the 250th District Court of Travis County, Texas (the “Court”), seeking to have the Court appoint a panel of independent and disinterested persons pursuant to Section H (3) of Article 5.14 of the Texas Business Corporation Act to investigate the allegations, and stay any shareholder derivative actions. Subsequently, on June 1, 2004, the Court issued an Order appointing Eugene Woznicki, Kenneth S. Shifrin, John D. Barnett and F. Gary Valdez as a panel of independent and disinterested persons (the “Panel”) to make determinations contemplated by Section F of Article 5.14 of the Texas Business Corporation Act in connection with the Demand Letter and staying any shareholder derivative actions relating to the letter until the Panel’s review was completed and a determination was made by the panel as to what, if any, further action was to be taken. Messrs. Woznicki, Shifrin and Barnett are independent directors of FIC. Mr. Valdez is neither a director nor an employee of FIC. Mr. Valdez is the founder and president of Focus Strategies, L.L.C. and is active in various community and civic organizations in the Austin, Texas area.

Following an extensive review of the claims made by the individual shareholder, the Panel, in January 2005, filed with the court a Petition for Declaratory Judgment pursuant to the Texas Declaratory Judgments Act and Article 5.14 of the Texas Business Corporations Act (the “Petition”). The Petition describes the process used by the Panel and its counsel in considering the matters raised in the Demand Letter and the submittal provided by counsel for the shareholder. The Petition advised the Court that, after consideration of the evidence obtained through its inquiry, the Panel had unanimously made a good faith determination that the continuation of the Committee’s derivative proceeding and the commencement of any further derivative proceedings based on the allegations made by the individual shareholder was not in the best interests of FIC.

On October 10, 2005, the 250th District Court of Travis County, Texas, heard for trial on the merits the matters raised by the Panel in the Petition (Financial Industries Corporation v. Tom Cook (Cause No. GN 401513). After consideration of the pleadings, evidence and authorities submitted by counsel for the Company, the Court issued a Final Judgment on October 10, 2005, in which it ruled that the determinations made by the Panel, as reflected in a report submitted to the Court by a Special Litigation Committee appointed by the Registrant’s Board of Directors, were made: (1) in good faith, (2) after the Panel conducted a reasonable inquiry, and (3) based on the factors deemed appropriate under the circumstances by the Panel. The Court’s ruling otherwise dismissed with prejudice the derivative proceedings involved in this matter. The Final Judgment was approved as to form and substance by counsel for the Registrant and by counsel for the defendant.  

Other Litigation

FIC and its insurance subsidiaries are regularly involved in litigation, both as a defendant and as a plaintiff. The litigation naming the insurance subsidiaries as defendant ordinarily involves our activities as a provider of insurance products. Management does not believe that any of this other litigation, either individually or in the aggregate, will have a material adverse effect on the Company’s business or financial condition.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

None

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

There were no matters submitted to a vote of security holders during the second quarter of 2005.

ITEM 5. OTHER INFORMATION

None

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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits

31.1 Certification of Chief Executive Officer of FIC pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2 Certification of Chief Financial Officer of FIC pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1 Certification of Chief Executive Officer of FIC pursuant to 18 U.S.C. Section 1350.

32.2 Certification of Chief Financial Officer of FIC pursuant to 18 U.S.C. Section 1350.

(b) Reports on Form 8-K

(i) On May 6, 2005 the Registrant filed a Current Report on Form 8-K.  The current report disclosed Appointment of a Principal Officer whereby the Board of the Company elected Michael P. Hydanus as Senior Vice President - Operations as of May 3, 2005.

(ii) On May 20, 2005 the Registrant filed a Current Report on Form 8-K.  The current report made a Regulation FD Disclosure regarding 2003 consolidated financial statements prepared in conformity with accounting principles generally accepted in the United States of America ("GAAP").

(iii) On May 24, 2005 the Registrant filed a Current Report on Form 8-K.  The current report disclosed a Temporary Suspension of Trading under Registrant’s Employee Benefit Plan, the InterContinental Life Corporation Employees Savings and Investment Plan, effective June 20, 2005 to August 22, 2005.

(iv) On June 3, 2005 the Registrant filed a Current Report on Form 8-K.  The current report made a Regulation FD Disclosure regarding a press release issued announcing completion of the sale of River Place Pointe by the Company on June 1, 2005.

(v) On June 14, 2005 the Registrant filed a Current Report on Form 8-K.  The current report made a Regulation FD Disclosure regarding the issuance of a shareholder letter by the Company regarding a delay in filing the 2003 10-K and 2004 financial documents.

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Signatures

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

	FINANCIAL INDUSTRIES CORPORATION
	(Registrant)
Date: January 12, 2007	By:/s/ Michael P. Hydanus
	Michael P. Hydanus
	Interim President and Chief Executive Officer
Date: January 12, 2007	By:/s/ Vincent L. Kasch
	Vincent L. Kasch
	Chief Financial Officer
	(Principal Accounting and Financial Officer)

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