We offer property and casualty insurance products to small businesses and individuals in New York State through our subsidiary, Kingstone Insurance Company (“KICO”).
We derive 98% of our revenue from KICO, which includes revenues from earned premiums, ceding commissions from quota share reinsurance, net investment income generated from our portfolio, and net realized gains and losses on investment securities. Earned premiums represent premiums received from insureds, which are recognized as revenue over the period of time that insurance coverage is provided (i.e., ratably over the life of the policy). A significant period of time normally elapses between the receipt of insurance premiums and the payment of insurance claims. During this time, KICO invests the premiums, earns investment income and generates net realized and unrealized investment gains and losses on investments.
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 typically have a term of one year. Accordingly, for a one-year policy written on July 1, 2010, we would earn half of the premiums in 2010 and the other half in 2011.
Net investment income was $754,000 in 2011 compared to $617,000 in 2010. The increase of $137,000, or 22.2%, was due to an increase in average invested assets in 2011 as compared to 2010, offset by an increase in investment expenses, including an adjustment to amortization of bond premium in 2011. The increase in cash and invested assets resulted primarily from increased operating cash flows. The tax equivalent investment yield, excluding cash, was 5.43% and 5.74% at December 31, 2011 and 2010, respectively.
Net realized gains on investments were $524,000 in 2011 compared to $349,000 in 2010. The increase of $175,000, or 50.1%, was primarily due to a recovery of $133,000 from the FDIC received in 2011 relating to a failed bank which was included in other than temporary impaired losses in 2009.
Other underwriting expenses were $7,373,000 in 2011 compared to $5,779,000 in 2010. The $1,594,000, or 27.6%, increase in other underwriting expenses was primarily due to expenses directly related to the increase in direct written premiums and additional employment costs due to both the hiring of additional staff needed to service our growth in written premiums and increases in annual salaries. Underwriting expenses as a percentage of direct written premiums was 18.1% in 2011 as compared to 17.4% in 2010.
(2) Includes direct and net catastrophe losses, and loss adjustment expenses $1,796,117 and $449,029, respectively for the year ended December 31, 2011.
As disclosed in Note 5 to the Consolidated Financial Statements, with respect to “Fair Value Measurements,” we define fair value under GAAP guidance as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants (an “exit price”). This GAAP guidance establishes a fair value hierarchy that 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 in GAAP 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, 2011 and December 31, 2010, 49% and 43%, respectively, of the investment portfolio recorded at fair value was priced based upon quoted market prices. As of December 31, 2011 and December 31, 2010, 50% and 56%, respectively, of the investment portfolio recorded at fair value was priced based upon observable inputs other than quoted prices.
There were 64 securities at December 31, 2011 that accounted for the gross unrealized loss, none of which were deemed by us to be other than temporarily impaired. There were 60 securities at December 31, 2010 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.
The primary sources of cash flow is from our insurance underwriting subsidiary, KICO, which are direct premiums written, ceding commissions from our quota share reinsurers, loss payments by our reinsurers, investment income and proceeds from the sale or maturity of investments. Funds are used by KICO for ceded premium payments to reinsurers, which are paid on a net basis after subtracting losses paid on reinsured claims and reinsurance commissions. KICO also uses funds for loss payments and loss adjustment expenses on our net business, commissions to producers, salaries and other underwriting expenses as well as to purchase investments and fixed assets.
We prepaid $703,000 of our notes payable during the year ended December 31, 2011. As of December 31, 2011, the outstanding principal balance of our notes payable was $747,000; such notes bear interest at the rate of 9.5% per annum and mature on July 10, 2014. We believe that our present cash flows as described above will be sufficient on a short-term basis and over the next 12 months to fund our company-wide working capital requirements.
Net cash provided by operating activities was $7,253,000 in 2011 as compared to $3,721,000 provided in 2010. The $3,532,000 increase in cash flows provided by operating activities in 2011 was primarily a result of the fluctuations in assets and liabilities relating to operating activities of KICO as affected by the growth in its operations which are described above.
Net cash used by financing activities was $881,000 in 2011 compared to $375,000 provided in 2010. The $1,256,000 decrease in cash flows from financing activities is a result of the $714,000 prepayment of notes payable in 2011, compared to $375,000 of net borrowings in 2010, purchase of treasury stock in 2011 only, and dividend payments of $230,000 in 2011 compared to no such payments in 2010. The 2011 uses of cash were offset by the $300,000 proceeds from our credit line that was opened in 2011.
Reinsurance recoverable from Maiden Reinsurance Company and Motors Insurance Corporation 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.
General liability commercial policies written by KICO, except for commercial auto policies, are reinsured under a 60% quota share treaty, which provides coverage up to $700,000 per occurrence. An excess of loss contract provides $1,500,000 of coverage in excess of the $700,000 included under the 60% quota share treaty for a total coverage up to $2,200,000 per occurrence.
Our reinsurance program is structured to enable us to reflect significant reductions in premiums written and earned and also provides income as a result of ceding commissions earned pursuant to the quota share reinsurance contracts. This structure has enabled us to significantly grow our premium volume while maintaining regulatory capital and other financial ratios generally within or below the expected ranges used for regulatory oversight purposes. Our participation in reinsurance arrangements does not relieve us from our obligations to policyholders.
Because of the exposure of our property and casualty business to catastrophic events, our operating results and financial condition may vary significantly from one period to the next. Catastrophes can be caused by various natural and man-made disasters, including earthquakes, wildfires, tornadoes, hurricanes, storms and certain types of terrorism. We may incur catastrophe losses in excess of: (1) those that we project would be incurred, (2) those that external modeling firms estimate would be incurred, (3) the average expected level used in pricing or (4) our current reinsurance coverage limits. Despite our catastrophe management programs, we are exposed to catastrophes that could have a material adverse effect on our operating results and financial condition. Our liquidity could be constrained by a catastrophe, or multiple catastrophes, which may result in extraordinary losses or a downgrade of our financial strength ratings.
We are subject to statutes and regulations of the state of New York , which generally require that any person or entity desiring to acquire direct or indirect control of KICO, our insurance company subsidiary, obtain prior regulatory approval. In addition, a change of control of Kingstone Companies, Inc. would require such approval. These laws may discourage potential acquisition proposals and may delay, deter or prevent a change of control of our company, including through transactions, and in particular unsolicited transactions, that some of our stockholders might consider to be desirable. Similar regulations may apply in other states in which we may operate.
Because the laws and regulations under which we operate are administered and enforced by a number of different governmental authorities, including state insurance regulators, state securities administrators and the SEC, each of which exercises a degree of interpretive latitude, we are subject to the risk that compliance with any particular regulator's or enforcement authority's interpretation of a legal issue may not result in compliance with another's interpretation of the same issue, particularly when compliance is judged in hindsight. In addition, there is risk that any particular regulator's or enforcement authority's interpretation of a legal issue may change over time to our detriment, or that changes in the overall legal and regulatory environment may, even absent any particular regulator's or enforcement authority's interpretation of a legal issue changing, cause us to change our views regarding the actions we need to take from a legal risk management perspective, thereby necessitating changes to our practices that may, in some cases, limit our ability to grow and improve the profitability of our business.
Difficult conditions in the economy generally could adversely affect our business and operating results.