We offer property and casualty insurance products to individuals and small businesses through our wholly owned subsidiary, Kingstone Insurance Company (“KICO”). KICO’s insureds are located primarily in downstate New York, consisting of New York City, Long Island and Westchester County, although we are actively writing business in New Jersey, Rhode Island, Pennsylvania and Massachusetts. We are licensed in the States of New York, New Jersey, Rhode Island, Massachusetts, Pennsylvania, Connecticut, Maine, and New Hampshire. For the year ended December 31, 2018, 93.7% of KICO’s direct written premiums came from the New York policies.
Net premiums earned: Net premiums earned is the earned portion of our written premiums, less that portion of premium that is ceded to third party reinsurers under reinsurance agreements. The amount ceded under these reinsurance agreements is based on a contractual formula contained in the individual reinsurance agreement. Insurance premiums are earned on a pro rata basis over the term of the policy. At the end of each reporting period, premiums written that are not earned are classified as unearned premiums and are earned in subsequent periods over the remaining term of the policy. Our insurance policies have a term of one year. Accordingly, for a one-year policy written on July 1, 2018, we would earn half of the premiums in 2018 and the other half in 2019.
Ceding commission revenue: Commissions on reinsurance premiums ceded are earned in a manner consistent with the recognition of the direct acquisition costs of the underlying insurance policies, generally on a pro-rata basis over the terms of the policies reinsured.
Other operating expenses: Other operating expenses include the corporate expenses of our holding company, Kingstone Companies, Inc. These expenses include executive employment costs, legal and auditing fees, and other costs directly associated with being a public company.
Income tax expense: We incur federal income tax expense on our consolidated operations as well as state income tax expense for our non-insurance underwriting subsidiaries.
A GAAP combined ratio, excluding catastrophe losses, between 82.0% and 84.0%.
Direct written premiums during the year ended December 31, 2018 (“Year Ended 2018”) were $146,716,000 compared to $121,575,000 during the year ended December 31, 2017 (“Year Ended 2017”). The increase of $25,141,000, or 20.7%, was primarily due to an increase in policies in-force during Year Ended 2018 as compared to Year Ended 2017. We wrote more new policies as a result of continued demand for our products in the markets that we serve. Policies in-force increased by 19.3% as of December 31, 2018 compared to December 31, 2017.
During Year Ended 2017, we started writing homeowners policies in New Jersey and Rhode Island. In Year Ended 2018, we started writing homeowners policies in Massachusetts. We refer to our New York business as our “Core” business and the business outside of New York as our “Expansion” business. Direct written premiums from our Expansion business were $9,080,000 in Year Ended 2018, compared to $1,800,000 in Year Ended 2017.
Without the effect of the 2018 Cut-off and 2017 Cut-off, net written premiums increased by $29,512,000, or 34.4%, in 2018 compared to 2017.
An increase in written premiums will, to a lesser extent than the change in quota share ceding rate, increase the premiums ceded under our excess of loss treaties. In Year Ended 2018, our ceded excess of loss reinsurance premiums increased by $177,000 over the comparable ceded premiums for Year Ended 2017. The increase was due to an increase in premiums subject to excess of loss reinsurance.
Most of the premiums written under our personal lines are also subject to our catastrophe treaties. An increase in our personal lines business gives rise to more property exposure, which increases our exposure to catastrophe risk; therefore, our premiums ceded under catastrophe treaties will increase. This results in an increase in premiums ceded under our catastrophe treaties provided that reinsurance rates are stable or are increasing. In Year Ended 2018, our premiums ceded under catastrophe treaties increased by $3,173,000 over the comparable ceded premiums for Year Ended 2017. The increase was due to an increase in our catastrophe coverage and an increase in premiums subject to catastrophe reinsurance, partially offset by more favorable reinsurance rates in Year Ended 2018. Our ceded catastrophe premiums are paid based on the total direct written premiums subject to the catastrophe reinsurance treaty.
The following table details the quota share provisional ceding commission rates in effect during Year Ended 2018 and Year Ended 2017. This table should be referred to in conjunction with the discussion for ceding commission revenue that follows.
The 2017/2019 Treaty and 2016/2017 Treaty structures limit the amount of contingent ceding commissions that we can receive by setting a higher provisional commission rate than the rates received in prior years. As a result of the higher upfront provisional ceding commissions that we receive, there is only a limited opportunity to earn contingent ceding commissions under these treaties. Under our current “net” treaty structure, catastrophe losses in excess of the $5,000,000 retention will fall outside of the quota share treaty and such losses will not have an impact on contingent ceding commissions. In Year Ended 2018, catastrophe losses of $1,506,000 were ceded under our personal lines quota share treaty. These catastrophe losses resulted in the Loss Ratios for the period July 1, 2017 through June 30, 2018 (attributable to the 2017/2019 Treaty) being higher than the contractual Loss Ratio at which provisional ceding commissions were being earned. As a result, we incurred a negative adjustment or reduction to the contingent ceding commissions of $459,000 relative to what would have been earned had the catastrophe losses not occurred. See “Reinsurance” below for changes to our personal lines quota share treaty effective July 1, 2018.
Net investment income was $6,186,000 in Year Ended 2018 compared to $4,133,000 in Year Ended 2017. The increase of $2,053,000, or 49.7%, was due to an increase in average invested assets in Year Ended 2018. The average yield on invested assets was 3.79% as of December 31, 2018 compared to 3.66% as of December 31, 2017. The pre-tax equivalent yield on invested assets was 3.44% and 3.70% as of December 31, 2018 and 2017, respectively.
The ratio of Core other underwriting expenses to Core net premiums earned was 19.4% in Year Ended 2018 compared to 22.2% in Year Ended 2017, a decrease of 1.3 percentage points.
The decrease in our other underwriting expense ratio excluding the impact of ceding commission revenue and commission expense was driven by a decline of 3.5 points from the impact of employment costs and other expenses attributable to our growing Core business.
Depreciation and amortization was $1,787,000 in Year Ended 2018 compared to $1,403,000 in Year Ended 2017. The increase of $384,000, or 27.4%, in depreciation and amortization was primarily due to depreciation of our new systems platform for handling business being written in Expansion states. The increase was also impacted by newly purchased assets used to upgrade our systems infrastructure and improvements to the Kingston, New York home office building from which we operate.
Interest expense in Year Ended 2018 was $1,822,000 and $60,000 in Year Ended 2017. We incurred interest expense in connection with our $30.0 million issuance of long-term debt in December 2017.
Income tax benefit in Year Ended 2018 was $86,000, which resulted in an effective tax rate of (2.9) %. Income tax expense in Year Ended 2017 was $4,323,000, which resulted in an effective tax rate of 30.2%. The change in our effective tax rate includes the change in the federal tax rate from 35% to 21% (see Note 2 in the accompanying Consolidated Financial Statements for further discussion over our accounting policies following Item 15 of this Annual Report). In addition, permanent differences in Year Ended 2018 had a greater impact on reducing the current year effective tax rate due to a decrease in income before taxes in Year Ended 2018 compared to the Year Ended 2017 amount. Income before taxes was $3,007,000 in Year Ended 2018 compared to income before taxes of $14,309,000 in Year Ended 2017.
Net income was $3,093,000 in Year Ended 2018 compared to $9,986,000 in Year Ended 2017. The decrease in net income of $6,893,000, or 69.0%, was due to the circumstances described above, which caused the increase in our net loss ratio, decrease in ceding commission revenue, net losses on investments, increases in other underwriting expenses, depreciation and amortization and interest expense, partially offset by the increase in our net premiums earned, net investment income and decrease in other operating expenses.
“Other” includes, among other things, premiums and loss and loss adjustment expenses from our participation in a mandatory state joint underwriting association and loss and loss adjustment expenses from commercial auto.
See discussions above with regard to “Net Written Premiums and Net Premiums Earned”, as to changes in quota share ceding rates, effective July 1, 2018 and 2017.
The year ended December, 2018, the effect of catastrophe loss on our net underwriting expense ratio includes the direct effect of reduced contingent ceding commission revenue by $459,068 and does not include the indirect effects of a $124,817 decrease in other underwriting expenses.
The following table presents a breakdown of the amortized cost, aggregate estimated fair value and unrealized gains and losses by investment type as of December 31, 2018 and 2017:
(1) In 2017, KICO placed certain residential mortgage backed securities as eligible collateral in a designated custodian account related to its membership in the FHLBNY. The eligible collateral would be pledged to FHLBNY if KICO draws an advance from the FHBLNY credit line. As of December 31, 2017, the estimated fair value of the eligible investments was $6,703,000. KICO will retain all rights regarding all securities if pledged as collateral. As of December 31, 2017, there was no outstanding balance on the FHLBNY credit line.
The following table presents a breakdown of the cost, estimated fair value, and gross gains and losses of investments in equity securities as of December 31, 2018 and 2017:
The table below summarizes the credit quality of our available-for-sale fixed-maturity securities as of December 31, 2018 and 2017 as rated by Standard and Poor’s (or, if unavailable from Standard and Poor’s, then Moody’s or Fitch):
As disclosed in Note 4 to the Consolidated Financial Statements, with respect to “Fair Value Measurements,” we define fair value as the price that would be received to sell an asset or paid to transfer a liability in a transaction involving identical or comparable assets or liabilities between market participants (an “exit price”). The fair value hierarchy distinguishes between inputs based on market data from independent sources (“observable inputs”) and a reporting entity’s internal assumptions based upon the best information available when external market data is limited or unavailable (“unobservable inputs”). The fair value hierarchy prioritizes fair value measurements into three levels based on the nature of the inputs. Quoted prices in active markets for identical assets have the highest priority (“Level 1”), followed by observable inputs other than quoted prices including prices for similar but not identical assets or liabilities (“Level 2”), and unobservable inputs, including the reporting entity’s estimates of the assumption that market participants would use, having the lowest priority (“Level 3”). As of December 31, 2018 and December 31, 2017, 81% and 73%, respectively, of the investment portfolio recorded at fair value was priced based upon quoted market prices.
There were 156 securities at December 31, 2018 that accounted for the gross unrealized loss, none of which were deemed by us to be other than temporarily impaired. There were 75 securities at December 31, 2017 that accounted for the gross unrealized loss, none of which were deemed by us to be other than temporarily impaired. Significant factors influencing our determination that unrealized losses were temporary included the magnitude of the unrealized losses in relation to each security’s cost, the nature of the investment and management’s intent not to sell these securities and it being not more likely than not that we will be required to sell these investments before anticipated recovery of fair value to our cost basis.
On December 19, 2017, we issued $30 million of our 5.50% Senior Unsecured Notes due December 30, 2022 pursuant to an underwritten public offering. The net proceeds to us were approximately $29,121,000. On December 20, 2017, we used $25,000,000 of the net proceeds from the debt offering to contribute capital to KICO, to support additional growth. The remainder of the net proceeds will be used for general corporate purposes. Interest will be payable semi-annually in arrears on June 30 and December 30 of each year, which began on June 30, 2018 at the rate of 5.50% per year from December 19, 2017.
For the year ended December 31, 2018, the primary source of cash flow for our holding company was the dividends received from KICO, subject to statutory restrictions. For the year ended December 31, 2018, KICO paid dividends of $3,600,000 to us.
As of December 31, 2018, invested assets and cash in our holding company was approximately $4,212,000. If the aforementioned sources of cash flow currently available are insufficient to cover our holding company cash requirements, we will seek to obtain additional financing.
Net cash provided by operating activities was $22,295,000 in 2018 as compared to $28,046,000 in 2017. The $5,751,000 decrease in cash flows provided by operating activities in 2018 was primarily a result of a decrease in net income (adjusted for non-cash items) of $3,513,000, fluctuations in other assets, accounts payable, accrued expenses and other liabilities of $4,679,000, partially offset by an increase in net cash arising from insurance related items from KICO of $2,441,000.
Net cash used in investing activities was $43,401,000 in 2018 compared to $47,626,000 in 2017. The $4,225,000 decrease in net cash used in investing activities was the result of a $16,012,000 increase in sales or maturities of invested assets and $92,000 decrease in fixed asset acquisitions in 2018, which offset the $15,879,000 increase in acquisitions of invested assets.
Reinsurance recoverable from Cavello Bay Reinsurance Limited and Motors Insurance Corporation (included in “Others”) are secured pursuant to collateralized trust agreements. Assets held in the two trusts are not included in our invested assets and investment income earned on these assets is credited to the two reinsurers respectively.
Our quota share reinsurance treaty in effect for 2018 for our personal lines business, which primarily consists of homeowners policies, was covered under the 2017/2019 Treaty. Our quota share reinsurance treaty in effect for 2017 for our personal lines business, which primarily consists of homeowners policies, was covered under the 2017/2019 Treaty and 2016/2017 Treaty.
We entered into new excess of loss and catastrophe reinsurance treaties effective July 1, 2018. Material terms for our reinsurance treaties in effect for the treaty years shown below are as follows:
Catastrophe coverage is limited on an annual basis to two times the per occurrence amounts. Effective July 1, 2016, the duration of a catastrophe occurrence from windstorm, hail, tornado, hurricane and cyclone was extended to 168 consecutive hours from 120 consecutive hours.
Effective July 1, 2016, reinstatement premium protection for $20,000,000 of catastrophe coverage in excess of $5,000,000.
Effective July 1, 2017, reinstatement premium protection for $145,000,000 of catastrophe coverage in excess of $5,000,000.
Treaty for July 1, 2018 - June 30, 2019 (the “2017/2019 Treaty”) is a two-year treaty with expiration date of June 30, 2019.
The single maximum risks per occurrence to which the Company is subject under the treaty years shown below are as follows:
The financial statements required by this Item 8 are included in this Annual Report following Item 15 hereof. As a first year accelerated filer, we are not required to provide supplementary financial information.