Underwriting income is a non-GAAP financial measure. See "Management’s Discussion and Analysis of Financial Condition and Results of Operations - Reconciliation of Non-GAAP Financial Measures" for a reconciliation of net income to underwriting income in accordance with GAAP.
The expense ratio is the ratio, expressed as a percentage, of underwriting, acquisition and insurance expenses to net earned premiums.
Return on equity represents net income expressed on an annualized basis as a percentage of average beginning and ending stockholders’ equity during the period.
Our goal is to deliver long-term value for our stockholders by growing our business and generating attractive returns. We seek to accomplish this by generating consistent and attractive underwriting profits while managing our capital prudently. We have built a company that is entrepreneurial and highly efficient, using our proprietary technology platform and leveraging the expertise of our highly experienced employees in our daily operations. We believe our systems and technology are at the digital forefront of the insurance industry, allowing us to quickly collect and analyze data, thereby improving our ability to manage our business and reducing response times for our customers. We believe that we have differentiated ourselves from our competitors by effectively leveraging technology, vigilantly controlling expenses and maintaining control over our underwriting and claims management.
capacity (known as a hard market), the E&S market may grow significantly more rapidly than the standard insurance market as business may shift from the standard market to the E&S market dramatically.
The effect of the MLQS on our results of operations is primarily reflected in our ceded written premiums, losses and loss adjustment expenses, as well as our underwriting, acquisition and insurance expenses. The following tables summarize the effect of the MLQS on our underwriting income for the years ended December 31, 2017, 2016 and 2015:
(3) Our adjusted loss ratio, adjusted expense ratio and adjusted combined ratio are non-GAAP financial measures. We define our adjusted loss ratio, adjusted expense ratio and adjusted combined ratio as each of our loss ratio, expense ratio and combined ratio, respectively, excluding the effects of the MLQS. We use these adjusted ratios as an internal performance measure in the management of our operations because we believe they give our management and other users of our financial information useful insight into our results of operations and our underlying business performance. Our adjusted loss ratio, adjusted expense ratio and adjusted combined ratio should not be viewed as substitutes for our loss ratio, expense ratio and combined ratio, respectively, which are presented in accordance with GAAP.
Net investment income is an important component of our results of operations. We earn investment income on our portfolio of cash and invested assets. Our cash and invested assets are primarily comprised of fixed maturity securities, and may also include cash and cash equivalents, equity securities and short-term investments. The principal factors that influence net investment income are the size of our investment portfolio and the yield on that portfolio. As measured by amortized cost (which excludes changes in fair value, such as changes in interest rates), the size of our investment portfolio is mainly a function of our invested equity capital along with premiums we receive from our insureds less payments on policyholder claims.
Net investment gains are a function of the difference between the amount received by us on the sale of a security and the security's amortized cost, as well as any "other-than-temporary" impairments recognized in earnings.
Currently all of our income tax expense relates to federal income taxes. Kinsale Insurance is generally not subject to income taxes in the states in which it operates; however, our non-insurance subsidiaries are subject to state income taxes. The amount of income tax expense or benefit recorded in future periods will depend on the jurisdictions in which we operate and the tax laws and regulations in effect. Among other things, the Tax Cuts and Jobs Act of 2017 ("TCJA") enacted on December 22, 2017 lowers the federal corporate tax rate from 35% to 21% starting January 1, 2018. Our income tax expense for periods beginning in 2018 will be based on the federal corporate income tax rate in the TCJA, and as a result, we expect our 2018 annual effective tax rate to be significantly lower than our current year effective tax rate.
Net income was $24.9 million for the year ended December 31, 2017 compared to $26.2 million for the year ended December 31, 2016, a decrease of $1.3 million, or 4.8%. Our underwriting income was $28.2 million for the year ended December 31, 2017, compared to $34.3 million for the year ended December 31, 2016, a decrease of $6.1 million, or 17.7%. The corresponding combined ratio was 84.0% for the year ended December 31, 2017 compared to 74.3% for the year ended December 31, 2016. As previously discussed, the MLQS was not renewed for the 2017 calendar year. Excluding the effect of the 2016 MLQS, underwriting income was $35.0 million and the corresponding adjusted combined ratio was 76.8% for the year ended December 31, 2016. The decrease in our underwriting income, excluding the effect of the 2016 MLQS, was attributable to higher losses incurred from catastrophes and lower favorable development of reserves from prior accident years, offset in part by an increase in net earned premiums in 2017.
Small business, which represented approximately 15.6% of our gross written premiums in 2017, increased by $7.6 million, or 27.7%, for the year ended December 31, 2017 over the prior year;
Construction, which represented approximately 21.8% of our gross written premiums in 2017, increased by $6.4 million, or 15.0%, for the year ended December 31, 2017 over the prior year, and
Products liability, which represented approximately 6.4% of our gross written premiums in 2017, increased by $4.1 million, or 40.9%, for the year ended December 31, 2017 over the prior year.
Net written premiums increased by $22.2 million, or 13.3%, to $189.5 million for the year ended December 31, 2017 from $167.3 million for the year ended December 31, 2016. This increase in net written premiums was primarily due to higher gross written premiums in 2017, offset in part by the termination and commutation of the MLQS. As a result of the successful completion of our IPO in August 2016, we terminated and commuted the 2016 MLQS on October 1, 2016. Our net retention ratio was 84.9% for the year ended December 31, 2017 compared to 88.7% for the year ended December 31, 2016. Excluding the effects of the MLQS, our net retention ratio was 83.3% for the year ended December 31, 2016.
Net earned premiums were $176.1 million for the year ended December 31, 2017 compared to $133.8 million for the year ended December 31, 2016, an increase of $42.2 million, or 31.6%. The increase was due to higher written premiums in 2017 compared to 2016 and from the non-renewal of the MLQS in 2017. Excluding the effects of the MLQS, net earned premiums were $150.8 million for the year ended December 31, 2016, a year-over-year increase of $25.2 million, or 16.7%.
Our loss ratio was 58.9% for the year ended December 31, 2017 compared to 53.0% for the year ended December 31, 2016. Excluding the effects of the MLQS, our adjusted loss ratio was 50.0% for the year ended December 31, 2016. The increase in the loss ratio for the year ended December 31, 2017 was due to higher catastrophe losses, net of reinsurance, of $9.0 million, primarily from Hurricanes Harvey and Irma and lower favorable development of reserves from prior accident years.
Our expense ratio was 25.1% for the year ended December 31, 2017 compared to 21.3% for the year ended December 31, 2016. The expense ratio was lower for the year ended December 31, 2016 due to the ceding commissions earned under the MLQS. As previously discussed, the MLQS was not renewed for the 2017 calendar
The following table summarizes the components of net investment income and net investment gains for the years ended December 31, 2017 and 2016:
We perform quarterly reviews of all securities within our investment portfolio to determine whether any other-than-temporary impairment has occurred. Management concluded that there were no other-than-temporary impairments from fixed maturity securities or equity securities with unrealized losses for the year ended December 31, 2017. We recognized an impairment loss of $0.3 million on our foreign market ETF for the year ended December 31, 2016, based on our assessment of the security's prospect of recovery in the near term. Management concluded that none of the fixed maturity securities with an unrealized loss at December 31, 2016 experienced an other-than-temporary impairment.
Our effective tax rate for the year ended December 31, 2017 was approximately 35.4% compared to 33.8% for the year ended December 31, 2016. In 2017, our effective tax rate differed from the statutory tax rate of 35% due to the charge related to the TCJA enacted on December 22, 2017. Among other things, the TCJA lowered the federal corporate tax rate from 35% to 21% starting January 1, 2018. As a result of the TCJA enactment in the fourth quarter of 2017, we re-measured our deferred tax balances to reflect the lower rate as required by applicable accounting standards. The re-measurement resulted in an increase to our tax expense of $1.9 million for the year ended December 31, 2017. In addition, the effective tax rate for the year ended December 31, 2017 reflected tax benefits related to tax-exempt interest income from municipal bonds and the recognition of tax benefits from share-based compensation. Our income tax expense for periods beginning in 2018 will be based on the new rate, and we expect our 2018 annual effective tax rate to be significantly lower than our current year effective tax rate, as a result of the reduction of the federal corporate income tax rate in the TCJA.
Our return on equity was 11.1% for the year ended December 31, 2017 compared to 16.2% for the year ended December 31, 2016. The decrease is primarily the result of higher average equity attributable to the additional equity raised in the IPO and lower net income.
Small business, which represented approximately 14.5% of our gross written premiums in 2016, increased by $5.9 million, or 27.3%, for the year ended December 31, 2016 over the prior year;
Construction, which represented approximately 22.4% of our gross written premiums in 2016, increased by $5.3 million, or 14.4%, for the year ended December 31, 2016 over the prior year, and
Our expense ratio was 21.3% for the year ended December 31, 2016 compared to 3.8% for the year ended December 31, 2015. As a result of the MLQS, our expense ratio for the year ended December 31, 2015 was low due to the ceding commissions earned under the MLQS.
Our combined ratio was 74.3% for the year ended December 31, 2016 compared to 60.6% for the year ended December 31, 2015. Excluding the effects of the MLQS, the adjusted combined ratio was 76.8% for the year ended December 31, 2016 compared to 77.5% for the year ended December 31, 2015.
The weighted average duration of our fixed income portfolio, including cash equivalents, was 3.7 years at December 31, 2016 and 3.2 years at December 31, 2015. Our investment portfolio had a gross return of 2.2% as of December 31, 2016, compared to 2.1% as of December 31, 2015.
Our effective tax rate for the year ended December 31, 2016 was approximately 33.8% compared to 33.6% for the year ended December 31, 2015. Our effective tax rate differed from the statutory tax rate in 2016 and 2015 primarily as a result favorable tax treatment on certain municipal bond interest income and dividends received from our equity investments.
State insurance laws restrict the ability of Kinsale Insurance to declare stockholder dividends without prior regulatory approval. State insurance regulators require insurance companies to maintain specified levels of statutory capital and surplus. The maximum dividend distribution Kinsale Insurance may make absent the approval or non-disapproval of the insurance regulatory authority in Arkansas is limited by Arkansas law to the greater of (1) 10% of policyholder surplus as of December 31 of the previous year, or (2) net income, not including realized capital gains, for the previous calendar year. The Arkansas statute also requires that dividends and other distributions be paid out of positive unassigned surplus without prior approval. The maximum amount of dividends Kinsale Insurance can pay us during 2018 without regulatory approval is $23.7 million. Insurance regulators have broad powers to ensure that statutory surplus remains at adequate levels, and there is no assurance that dividends of the maximum amount calculated under any applicable formula would be permitted. In the future, state insurance regulatory authorities that have jurisdiction over the payment of dividends by Kinsale Insurance may adopt statutory provisions more restrictive than those currently in effect. Kinsale Insurance paid $4.5 million of dividends to us during 2017. See also "Risk Factors - Risks Related to Our Business and Our Industry - Because we are a holding company and substantially all of our operations are conducted by our insurance subsidiary, our ability to pay dividends depends on our ability to obtain cash dividends or other permitted payments from our insurance subsidiary."
As of December 31, 2017, our holding company had $1.5 million in cash and investments, compared to $1.9 million as of December 31, 2016.
For the year ended December 31, 2017, net cash used in financing activities was $4.0 million and reflected dividends paid of $0.24 per common share, or $5.0 million in the aggregate. During 2017 we received proceeds of $1.1 million from the exercise of vested stock options. For the year ended December 31, 2016, net cash provided by financing activities was $40.6 million and included proceeds from the IPO of $72.8 million, of which $40 million was contributed to our insurance subsidiary, Kinsale Insurance, and $30 million was used to paydown our debt facility. In addition, we paid dividends of $0.10 per common share, or $2.1 million in the aggregate. For the year ended December 31, 2015, cash provided by financing activities included proceeds from the drawdown of our debt facility of $2.0 million.
On December 8, 2016, we made a voluntary prepayment to PrivateBank of $27.7 million, the total amount outstanding under the Credit Agreement. As a result of the prepayment, the Credit Agreement, which would have otherwise terminated in December 2020, was terminated early in accordance with its terms.
We enter into reinsurance contracts to limit our exposure to potential large losses as well as to provide additional capacity for growth. Our reinsurance is primarily contracted under quota-share reinsurance contracts and excess of loss contracts. In quota share reinsurance, the reinsurer agrees to assume a specified percentage of the ceding company's losses arising out of a defined class of business in exchange for a corresponding percentage of premiums, net of a ceding commission. In excess of loss reinsurance, the reinsurer agrees to assume all or a portion of the ceding company's losses, in excess of a specified amount. In excess of loss reinsurance, the premium payable to the reinsurer is negotiated by the parties based on their assessment of the amount of risk being ceded to the reinsurer because the reinsurer does not share proportionately in the ceding company's losses.
Reinsurance contracts do not relieve us from our obligations to policyholders. Failure of the reinsurer to honor its obligations could result in losses to us, and therefore, we establish allowances for amounts considered uncollectible. At December 31, 2017, there was no allowance for uncollectible reinsurance. As of December 31, 2017, Kinsale Insurance has only contracted with reinsurers with A.M. Best financial strength ratings of "A" (Excellent) or better. At December 31, 2017, the net reinsurance receivable, defined as the sum of paid and unpaid reinsurance recoverables, ceded unearned premiums less reinsurance payables, from five reinsurers represented 92.4% of the total balance.
At December 31, 2017, total stockholders' equity was $238.2 million and tangible stockholders' equity was $235.4 million, compared to total stockholders' equity of $210.2 million and tangible stockholders' equity of $207.9 million at December 31, 2016. The increase in both total and tangible stockholders' equity was primarily due to net income earned for the year ended December 31, 2017 and the increase in unrealized gains related to available-for-sale securities, net of taxes. The increase was offset in part by dividends paid during the year. At December 31, 2015, our total stockholders' equity was $113.5 million and tangible stockholders' equity was $111.2 million. The increase in both total and tangible stockholders' equity at December 31, 2016 compared to December 31, 2015 was primarily due to the net proceeds we received from our IPO and from net income earned for the year ended December 31, 2016.
calculated in accordance with GAAP. We use tangible stockholders' equity internally to evaluate the strength of our balance sheet and to compare returns relative to this measure.
Stockholders' equity at December 31, 2017, 2016 and 2015, reconciles to tangible stockholders' equity as follows:
As of January 1, 2016, we were authorized to issue 18,333,333 shares of Common Stock, $0.0001 par value per share, of which 15,000,000 shares were designated as Class A Common Stock and 3,333,333 were designated as Class B Common Stock. On July 28, 2016, in connection with the IPO, we amended and restated our certificate of incorporation to recapitalize our authorized capital stock to consist of 400,000,000 shares of common stock, par value $0.01 per share, and 100,000,000 shares of preferred stock, par value $0.01 per share.
the number of shares of common stock equal to the amount of accrued and unpaid dividends based on a reclassification date of July 28, 2016, or $90.3 million, divided by the IPO price of $16.00 per share, plus
On February 1, 2017, the Company’s Board of Directors declared a cash dividend of $0.06 per share of common stock. This dividend was paid on March 15, 2017 to all stockholders of record on February 15, 2017.
On August 10, 2017, the Company’s Board of Directors declared a cash dividend of $0.06 per share of common stock. This dividend was paid on September 15, 2017 to all stockholders of record on August 31, 2017.
On November 8, 2017, the Company’s Board of Directors declared a cash dividend of $0.06 per share of common stock. This dividend was paid on December 15, 2017 to all stockholders of record on November 30, 2017.
On February 12, 2018, the Company’s Board of Directors declared a cash dividend of $0.07 per share of common stock. This dividend is payable on March 15, 2018 to all stockholders of record on February 28, 2018.
At December 31, 2017, the amortized cost and fair value on available-for-sale securities were as follows:
The amortized cost and fair value of our available-for-sale investments in fixed maturity securities summarized by contractual maturity as of December 31, 2017, were as follows:
Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties, and the lenders may have the right to put the securities back to the borrower.
Net income for the years ended December 31, 2017, 2016 and 2015, reconciles to underwriting income as follows:
experience develops or as new information becomes known to us. Such adjustments are included in current operations. Additionally, during the loss settlement period, it often becomes necessary to refine and adjust the estimates of liability on a claim either upward or downward. Even after such adjustments, ultimate liability may exceed or be less than the revised estimates. Accordingly, the ultimate settlement of losses and the related loss adjustment expenses may vary significantly from the estimate included in our consolidated financial statements.
We categorize our reserves for unpaid losses and loss adjustment expenses into two types: case reserves and reserves for incurred but not yet reported losses ("IBNR"). Our gross reserves for losses and loss adjustment expenses at December 31, 2017 were $315.7 million, and of this amount, 81.2% related to IBNR. Our net reserves for losses and loss adjustment expenses at December 31, 2017 were $267.5 million, and of this amount, 81.1% related to IBNR. A 5% change in net IBNR reserves at December 31, 2017 would equate to an $10.8 million change in the reserve for losses and loss adjustment expenses at such date, as well as $7.0 million change in net income, a 3.0% change in stockholders' equity and a 3.0% change in tangible equity, in each case at or for the year ended December 31, 2017.
The following tables summarize our gross and net reserves for unpaid losses and loss adjustment expenses at December 31, 2017 and 2016:
Case reserves are established for individual claims that have been reported to us. We are notified of losses by our insureds or their brokers. Based on the information provided, we establish case reserves by estimating the ultimate losses from the claim, including defense costs associated with the ultimate settlement of the claim. Our claims department personnel use their knowledge of the specific claim along with advice from internal and external experts, including underwriters and legal counsel, to estimate the expected ultimate losses.
The table below quantifies the impact of potential reserve deviations from our carried reserve at December 31, 2017. We applied sensitivity factors to incurred losses for the three most recent accident years and to the carried reserve for all prior accident years combined. We believe that potential changes such as these would not have a material impact on our liquidity.
We review all securities with unrealized losses on a quarterly basis to assess whether the decline in the securities’ fair value is deemed to be other-than-temporary. The determination that an investment has incurred an other-than-temporary loss in value requires judgment, and we consider a number factors in completing our impairment review, including the length of time and the extent to which fair value has been below cost and the financial condition and near-term prospects of the issuer. For fixed maturities, we consider whether we intend to sell the security, or if it is more likely than not that we will be required to sell the security before recovery, or have the ability to recover all amounts outstanding when contractually due. For equity securities, we evaluate the near-term prospects of these investments in relation to the severity and duration of the impairment and, we consider our ability and intent to hold the security for a period of time sufficient to allow for anticipated recovery.
For fixed maturities where we intend to sell the security or it is more likely than not that we will be required to sell the security before recovery of its amortized cost, a decline in fair value is considered to be other-than-temporary and is recognized in net loss based on the fair value of the security at the time of assessment, resulting in a new cost basis for the security. If the decline in fair value of a fixed maturity security below its amortized cost is considered to be other-than-temporary based upon other considerations, we compare the estimated present value of the cash flows expected to be collected to the amortized cost of the security. The extent to which the estimated present value of the cash flows expected to be collected is less than the amortized cost of the security represents the credit-related portion of the other-than-temporary impairment and is recognized in net loss, resulting in a new cost basis for the security. Any remaining decline in fair value represents the noncredit portion of the other-than-temporary impairment and is recognized in other comprehensive loss. For equity securities, a decline in fair value that is considered to be other-than-temporary is recognized in net loss based on the fair value of the security at the time of assessment, resulting in a new cost basis for the security.
When assessing whether we intend to sell a fixed maturity security, or if it is more likely than not that we will be required to sell a fixed maturity security before recovery of its amortized cost, we evaluate facts and circumstances including, but not limited to, decisions to reposition the investment portfolio and potential sales of investments to meet cash flow needs. The day-to-day management of our investment portfolio is outsourced to a third-party investment manager. For securities with unrealized losses, our investment manager may believe that the preferred course of action is to hold those securities until such losses are recovered. However, the dynamic nature of the portfolio management may result in a subsequent decision to sell the security and realize the loss based upon a change in the market and other factors described above. Our investment manager notifies us of rating agency downgrades of securities in their portfolios as well as any potential investment valuation issues at the end of each quarter. Our investment manager is also required to notify us of, and receive approval for, any other-than-temporary impairments it has identified. For the year ended December 31, 2017, there were no other-than-temporary impairments recognized. For the year ended December 31, 2016, we recorded an other-than-temporary impairment of $0.3 million related to our foreign market ETF. See Note 2 of the notes to the consolidated financial statements for further discussion regarding our investments.
On December 22, 2017, the President of the United States signed into law the TCJA. The legislation significantly changes U.S. tax law by, among other things, lowering corporate income tax rates from 35% to 21%, effective January 1, 2018. U.S. GAAP requires companies to recognize the effect of tax law changes in the period of enactment. The SEC staff
In January 2016, FASB issued ASU 2016-01, "Financial Instruments - Overall: Recognition and Measurement of Financial Assets and Financial Liabilities," which requires equity investments to be measured at fair value with changes in fair value recognized in net income, requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes, requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset, and eliminates the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost. The amendments in this ASU are effective for public companies for annual reporting periods beginning after December 15, 2017, including interim periods within those fiscal years. Upon adoption, a cumulative-effect adjustment to the balance sheet will be made as of the beginning of the fiscal year of adoption. For the year ended December 31, 2017, accumulated other comprehensive income included $6.5 million of net unrealized gains on equity securities, net of taxes. Adoption of this ASU is not expected to have a material impact on our financial position or cash flows, but may have a material impact on our results of operations in the future as changes in the fair value of equity instruments will be presented in net income rather than other comprehensive income.
This ASU is effective for annual and interim reporting periods beginning after December 15, 2019. Early adoption is permitted beginning after December 15, 2018. Upon adoption, the update will be applied using the modified-
retrospective approach, by which a cumulative-effect adjustment will be made to retained earnings as of the beginning of the first reporting period presented. We are currently evaluating the impact of the adoption on our consolidated financial statements.
To our knowledge, there are no other prospective accounting standards which, upon their effective date, would have a material impact on our consolidated financial statements.
Management evaluated the effectiveness of our internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Management reviewed the results of its assessment with the Audit Committee of our Board of Directors. Based on our evaluation, we have concluded that we maintained effective internal control over financial reporting as of December 31, 2017.
The Company’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s consolidated financial statements and an opinion on the Company’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
Kinsale Capital Group, Inc., an insurance holding company, is a Delaware corporation that was formed in 2009 and conducts its operations through its wholly-owned subsidiaries. Kinsale Capital Group Inc. writes excess and surplus lines insurance on a non-admitted basis principally through its insurance subsidiary, Kinsale Insurance Company ("Kinsale Insurance"), which is authorized to write business in 50 states, the District of Columbia, the Commonwealth of Puerto Rico and the U.S. Virgin Islands. Kinsale Capital Group, Inc. also markets certain products through its subsidiary, Aspera Insurance Services, Inc. ("Aspera"), an insurance broker. Aspera is authorized to conduct business in Alabama, California, Connecticut, Delaware, Florida, Georgia, Louisiana, Maine, Maryland, Massachusetts, Mississippi, New Hampshire, New Jersey, New York, North Carolina, Pennsylvania, Rhode Island, South Carolina, Texas and Virginia.
The accompanying consolidated financial statements include the accounts of Kinsale Capital Group, Inc. and its wholly-owned subsidiaries (referred to as "Kinsale" or, with its subsidiaries, the "Company"). All significant intercompany balances and transactions have been eliminated in consolidation.
The Company regularly evaluates its fixed maturity securities and equity securities using both quantitative and qualitative criteria to determine impairment losses for other-than-temporary declines in the fair value of the investments. See Note 2 for further discussion of other-than-temporary impairments ("OTTI").
Interest on fixed maturity securities is credited to earnings as it accrues. Premiums and discounts are amortized or accreted over the lives of the related fixed maturities. Dividends on equity securities are included in earnings on the ex-dividend date. Realized gains and losses on disposition of investments are based on specific identification of the investments sold on the trade date.
Premiums receivable balances are carried at face value, net of any allowance for doubtful accounts. The allowance for doubtful accounts represents an estimate of amounts considered uncollectible based on the Company’s assessment of the collectability of receivables that are past due. The Company recorded an allowance for doubtful accounts of $2.1 million and $2.0 million at December 31, 2017 and 2016, respectively, and believes that all other amounts due are collectible.
Property and equipment are stated at cost less accumulated depreciation. Depreciation of property and equipment is calculated using the straight-line method over the estimated useful lives of the assets. The estimated useful lives range from seven to ten years for furniture and equipment, three to seven years for electronic data processing hardware and software, and from two to six years for leasehold improvements, which is the shorter of the estimated useful life or the lease term. Property and equipment is included in "other assets" in the accompanying consolidated balance sheets.
Intangible assets are recorded at fair value at the date of acquisition. The Company's intangible assets are comprised solely of indefinite-lived intangible assets, which arise from regulatory approvals granted by the various state insurance departments to write insurance business in the respective states on a non-admitted basis. In accordance with U.S. GAAP, amortization of indefinite-lived intangible assets is not permitted. Indefinite-lived intangible assets are tested for impairment during the fourth quarter on an annual basis, or earlier if there is reason to suspect that their values may have been diminished or impaired. There were no impairments recognized in 2017, 2016, or 2015. In addition, as of December 31, 2017, no triggering events occurred that suggested an updated review was necessary.
Reserves for unpaid losses and loss adjustment expenses represent management's best estimate of ultimate unpaid cost of all reported and unreported losses and loss adjustment expenses incurred prior to the financial statement date. The estimates are based on an actuarial method that uses management’s initial expected loss ratio, expected reporting patterns for losses based on industry data and the Company’s actual reported losses and loss adjustment expenses. All estimates are regularly reviewed and, as experience develops and new information becomes known, the reserves for unpaid losses and loss adjustment expenses are adjusted as necessary. Such adjustments are reflected in the results of operations in the period in which they are determined. Although management believes that the reserves for losses and loss adjustment expenses are reasonable, due to the inherent uncertainty in estimating reserves for unpaid losses and loss adjustment expenses, it is possible that the Company’s actual incurred losses and loss adjustment expenses will not develop in a manner consistent with the assumptions inherent in the determination of these reserves. If actual liabilities do exceed recorded amounts, there will be an adverse effect. Furthermore, we may determine that recorded reserves are more than adequate to cover expected losses which will result in a reduction to the reserves. The Company believes that the reserves for unpaid losses and loss adjustment expenses at December 31, 2017 are adequate and represent a reasonable estimate of the Company's future obligations. See Note 7 for a further discussion of reserves for unpaid losses and loss adjustment expenses.
Deferred income tax assets and liabilities are determined based on the difference between the financial statement and the tax bases of assets and liabilities, using enacted tax rates expected to be in effect during the year in which the basis differences reverse. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. Valuation allowances are recorded when it is more likely than not that some portion, or all, of the deferred tax assets will not be realizable. Management evaluates the realizability of the deferred tax assets and assesses the need for any valuation allowance adjustment. Valuation allowances on deferred tax assets are estimated based on the Company's assessment of the realizability of such amounts.
other fixed maturity securities, the pricing vendors use a pricing methodology involving the market approach, including pricing models which use prices and relevant market information regarding a particular security or securities with similar characteristics to establish a valuation. The estimates of fair value of these fixed maturity investments are included in the amounts disclosed as Level 2. For those bonds where significant inputs are unobservable, Level 3 inputs, the Company's investment manager obtains valuations from pricing vendors using the market approach and income approach valuation techniques.
In February 2016, the FASB issued ASU 2016-02, "Leases (Topic 842)" to improve the financial reporting of leasing transactions. Under this ASU, lessees will recognize a right-of-use asset and corresponding liability on the balance sheet for all leases, except for leases covering a period of fewer than 12 months. The liability is to be measured as the present value of the future minimum lease payments taking into account renewal options if applicable plus initial incremental direct costs such as commissions. The minimum payments are discounted using the rate implicit in the lease or, if not known, the lessee’s incremental borrowing rate. The lessee’s income statement treatment for leases will vary depending on the nature of what is being leased. A financing type lease is present when, among other matters, the asset is being leased for a substantial portion of its economic life or has an end-of-term title transfer or a bargain purchase option as in today’s practice. The payment of the liability set up for such leases will be apportioned between interest and principal; the right-of use asset will be generally amortized on a straight-line basis. If the lease does not qualify as a financing type lease, it will be accounted for on the income statement as rent on a straight-line basis. This ASU is effective for annual
On March 30, 2017, the FASB issued ASU 2017-08, "Premium Amortization on Purchased Callable Debt Securities," which shortens the amortization period of the premium for certain callable debt securities, from the contractual maturity date to the earliest call date. This ASU is effective in fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted, including in an interim period. Upon adoption, the update will be applied on a modified retrospective basis, with a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period presented. The Company is currently evaluating the impact of the adoption on its consolidated financial statements.
The Company regularly reviews all securities with unrealized losses to assess whether the decline in the securities’ fair value is deemed to be an OTTI. The Company considers a number of factors in completing its OTTI review, including the length of time and the extent to which fair value has been below cost and the financial condition of an issuer. In addition to specific issuer information, the Company also evaluates the current market and interest rate environment.
Generally, a change in a security’s value caused by a change in the market or interest rate environment does not constitute an OTTI, but rather a temporary decline in fair value.
For fixed maturities where a decline in fair value is considered to be other-than-temporary and the Company intends to sell the security, or it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost, an impairment is recognized in net income based on the fair value of the security at the time of assessment, resulting in a new cost basis for the security. If the decline in fair value of a fixed maturity security below its amortized cost is considered to be other-than-temporary based upon other considerations, the Company compares the estimated present value of the cash flows expected to be collected to the amortized cost of the security. The extent to which the estimated present value of the cash flows expected to be collected is less than the amortized cost of the security represents the credit-related portion of the OTTI, which is recognized in net income, resulting in a new cost basis for the security. Any remaining decline in fair value represents the noncredit portion of the OTTI, which is recognized in other comprehensive income. For equity securities, a decline in fair value that is considered to be other-than-temporary is recognized in net income based on the fair value of the security at the time of assessment, resulting in a new cost basis for the security.
Within its equity security portfolio, the Company holds an ETF with exposure across developed and emerging non-U.S. equity markets around the world. This ETF had been in an unrealized loss position for greater than one year and, management concluded based upon its review, it was other-than-temporarily impaired. The Company recognized an impairment loss of $0.3 million on this fund for the year ended December 31, 2016.
The amortized cost and estimated fair value of available-for-sale fixed maturity securities at December 31, 2017 are summarized, by contractual maturity, as follows:
The Company recorded a payable for investments purchased, not yet settled, of $1.0 million at December 31, 2017 and $0.6 million at December 31, 2016. These payable were included in the "other liabilities" line item of the balance sheet and were treated as a non-cash transaction for purposes of cash flow presentation.
Fair values of the Company's investment portfolio are estimated using unadjusted prices obtained by its investment manager from nationally recognized third party pricing services, where available. For securities where the Company is unable to obtain fair values from a pricing service or broker, fair values are estimated using information obtained from the Company's investment manager. Management performs several procedures to ascertain the reasonableness of investment values included in the consolidated financial statements at December 31, 2017, including 1) obtaining and reviewing internal control reports from the Company's investment manager that assess fair values from third party pricing services, 2) discussing with the Company's investment manager its process for reviewing and validating pricing obtained from third party pricing services and 3) reviewing the security pricing received from the Company's investment manager and monitoring changes in unrealized gains and losses at the individual security level. The Company has evaluated the various types of securities in its investment portfolio to determine an appropriate fair value hierarchy level based upon trading activity and the observability of market inputs.
The following table presents the amounts of policy acquisition costs deferred and amortized for the years ended:
Other operating expenses within underwriting, acquisition and insurance expenses included salaries, employee benefits and bonus expense of $17.7 million, $18.7 million and $15.5 million, for the years ended December 31, 2017, 2016 and 2015, respectively.
The Company’s subsidiaries file a consolidated U.S. federal income tax return. Under a tax sharing agreement, KCGI collects from or refunds to its subsidiaries the amount of taxes determined as if KCGI and the subsidiaries filed separate returns. The Company is no longer subject to income tax examination by tax authorities for the years ended before January 1, 2014.
Income tax expense includes the following components for the years ending December 31, 2017, 2016 and 2015:
The Company paid $13.5 million, $13.3 million and $13.6 million in federal income taxes during the years ended December 31, 2017, 2016 and 2015, respectively. Current income taxes receivable was $0.8 million at December 31, 2017 and income taxes payable was $0.1 million at December 31, 2016, and were included in "other assets" and "other liabilities" in the accompanying consolidated balance sheets.
On December 22, 2017, the President of the United States signed into law the Tax Cuts and Jobs Act of 2017 (the "TCJA"). The legislation significantly changes U.S. tax law by, among other things, lowering corporate income tax rates from 35% to 21%, effective January 1, 2018, and modifying the manner in which property and casualty insurance loss reserves are computed for federal income tax purposes. In computing its taxable income, the Company records a deduction for unpaid losses and loss adjustment expenses. The deduction is discounted using interest rates and loss payment patterns prescribed by the U.S. Treasury. The TCJA changes the prescribed interest rates, which are now based on corporate bond yield curves, and extends the applicable time periods for the loss payment pattern period for long-tailed lines of business. The changes are effective for tax years beginning after 2017
The Company measures deferred tax assets and liabilities using enacted tax rates that will apply in the years in which the temporary differences are expected to be recovered or paid. Accordingly, the Company’s deferred tax assets and liabilities were remeasured to reflect the reduction in the U.S. corporate income tax rate from 35% to 21%, resulting in a $1.9 million increase in income tax expense and a corresponding decrease in net deferred tax assets as of the enactment date.
The Company recognized the entire remaining uncertain tax position (UTP) of $1.0 million in the third quarter of 2017 due to lapse of the statute of limitations. The recognition of the UTP had no impact on the effective tax rate as it resulted in a decrease of current taxes and an offsetting increase to deferred taxes.
The reserves for unpaid losses and loss adjustment expenses represent the Company's estimated ultimate cost of all unreported and reported but unpaid insured claims and the cost to adjust these losses that have occurred as of or before the balance sheet date. Reserves are estimated using individual case-basis valuations of reported claims and statistical analyses. Case reserves are established for individual claims that have been reported to the Company, typically by the Company's insureds or their brokers. Based on the information provided, case reserves are established by estimating the ultimate losses from the claim, including defense costs associated with the ultimate settlement of the claim. Incurred-but-not-reported ("IBNR") reserves are determined using actuarial methods to estimate losses that have occurred but have not yet been reported to the Company. The incurred Bornhuetter-Ferguson actuarial method ("BF method") is used to arrive at the Company's loss reserve estimates for each line of business. This method estimates the reserves based on the initial expected loss ratio and expected reporting patterns for losses. Because the Company has a limited number of years of loss experience compared to the period over which losses are expected to be reported, the Company uses industry and peer-group data as a basis for selecting its expected reporting patterns.
As part of the reserving process, the Company reviews historical data and considers the effect of various factors on claims development patterns including polices written on a "claims made" versus "occurrence" basis. Policies written on a claims made basis provide coverage to the insured only for losses incurred during the coverage period, and only if the claim was reported during a specified reporting period. Policies written on an occurrence basis provide coverage to the insured for liabilities arising from events occurring during the term of the policy, regardless of when a claim is actually made. Accordingly, claims related to policies written on an occurrence basis may arise many years after a policy has lapsed. Property losses, while written on an occurrence basis, are generally reported within a short time from the date of loss, and in most instances, property claims are settled and paid within a relatively short period of time.
During the year ended December 31, 2016, our net incurred losses for accident years 2015 and prior developed favorably by $12.7 million. This favorable development included $6.1 million for the 2015 accident year and $6.6 million of favorable development for accident years 2014 and prior. The favorable development was primarily due to reported losses emerging at a lower level than expected, across most lines of business.
The following is information about incurred and paid claims development as of December 31, 2017, net of reinsurance, as well as cumulative claim frequency and the total of IBNR liabilities plus expected development on reported claims included within the net incurred claims amounts. The development and claims duration tables below exclude the commuted MLQS contracts,
The information about incurred and paid claims development for the years ended December 31, 2016 to December 31, 2010, is presented as unaudited supplementary information.
The following is supplementary information about average historical claims duration as of December 31, 2017:
Incurred losses and loss adjustment expenses were net of reinsurance recoverables (ceded incurred losses and loss adjustment expenses) of $12.2 million, $13.7 million and $41.2 million for the years ended December 31, 2017, 2016 and 2015, respectively.
The Company participated in a MLQS treaty that transferred a proportion of the risk related to certain lines of business written by its subsidiary, Kinsale Insurance, to reinsurers that received a proportion of the direct written premiums on that business. The Company's MLQS contract also reduced the amount of capital required to support the insurance operations of Kinsale Insurance. Under the terms of the MLQS contract, the Company received a provisional ceding commission and paid a reinsurance margin, as long as the reinsurers were not in a loss position on the contract. The MLQS contract included a sliding scale commission provision that reduced or increased the ceding commission based on the loss experience of the business ceded. Under the contract, the Company was entitled to an additional contingent profit commission up to an amount equal to all of the reinsurers’ profits above the margin based on the underwriting results of the business ceded, upon commutation of the contract. The contracts had a loss ratio cap of 110%, which restricted the Company from ceding any losses in excess of 110% of ceded earned premiums to the reinsurers. As a result of the initial public offering, the Company did not renew the MLQS treaty for calendar year 2017.
Effective January 1, 2016, the Company commuted the 2014 MLQS, which reduced reinsurance recoverables on unpaid losses and receivable from reinsurers by $34.2 million, with a corresponding reduction to funds held for reinsurers. Effective October 1, 2016, the Company terminated and commuted the 2016 MLQS. The commutation reduced reinsurance recoverables on unpaid losses and receivable from reinsurers by approximately $15.5 million with a corresponding reduction to funds held for reinsurers.
Effective January 1, 2017, the Company commuted the 2015 MLQS. The commutation reduced reinsurance recoverables on unpaid losses and receivable from reinsurers by approximately $36.5 million, with a corresponding reduction to funds held for reinsurers. There are no remaining MLQS contracts outstanding as of January 1, 2017.
On July 28, 2016, the Company had outstanding grants of 1,783,858 restricted shares of Class B Common Stock. At that date, all restricted shares of Class B Common Stock were reclassified into 1,286,036 shares of common stock equal to a conversion ratio of 0.72095061. The conversion ratio was calculated based on the IPO price of $16.00 per share.
A summary of option activity under the employee share option plan as of December 31, 2017, and changes during the year then ended is presented below:
The weighted average grant date fair value of options granted during 2016 was $2.71 per share. The total intrinsic value of options exercised during the year ended December 31, 2017 was $1.5 million. There were no options exercised during 2016.
Prior to the IPO, under the Kinsale Capital Group, Inc. 2010 Incentive Plan (the "2010 Incentive Plan"), the Company granted shares of restricted Class B Common Stock to certain directors, executive officers, and employees. In connection with the reclassification on July 28, 2016, all unvested shares of Class B Common Stock were immediately vested and reclassified into a single class of common stock. The 2010 Incentive Plan was then terminated upon the completion of the IPO.
The Company recognized total equity-based compensation expense of $0.7 million, $0.5 million and $0.1 million for the years ended December 31, 2017, 2016 and 2015, respectively.
Basic earnings per share for each class of common stock was computed by dividing the earnings attributable to the common stockholders by the weighted average number of shares of each respective class of common stock outstanding during the period. Diluted earnings per share attributable to each class of common stock was computed by dividing earnings attributable to common stockholders by the weighted average shares outstanding for each respective class of common stock outstanding during the period, including potentially dilutive shares of common stock for the period determined using the treasury stock method. There were no potentially dilutive shares attributable to Class A common stockholders. For purposes of the diluted earnings per share attributable to Class B common stockholders calculation, unvested restricted grants of common stock were considered to be potentially dilutive shares of common stock. There were no material anti-dilutive Class B shares for the years ended December 31, 2016 and 2015. See Note 9, "Stockholders' Equity," for details regarding changes to the Company’s capital structure on July 28, 2016.
There were no anti-dilutive stock options for the years ended December 31, 2017 and 2016.
On March 10, 2014 and September 29, 2014, the Company amended the Credit Agreement with PrivateBank to increase the term loan commitment to $25.0 million and $28.0 million, respectively. On December 4, 2015, the Company amended the Credit Agreement to increase the term loan commitment to $30.0 million and extended the term loan maturity to December 4, 2020.
Interest on the term loan accrued daily at a rate equal to the 3-month LIBOR plus a margin. The margin was 2.75% as of December 31, 2016 and 2015. Total interest expense on the Credit Agreement was $1.3 million for the year ended December 31, 2016 and $1.2 million for the year ended December 31, 2015. Interest expense was included in "other expenses" on the accompanying statements of income and comprehensive income. Interest paid was $1.0 million for the year ending December 31, 2016, and $1.1 million for the year ending December 31, 2015.
Kinsale Insurance is subject to risk-based capital ("RBC") requirements. RBC is a method developed by the NAIC to determine the minimum amount of statutory capital appropriate for an insurance company to support its overall business operations in consideration of its size and risk profile. The formula for determining the amount of RBC is calculated using various factors, weighted based on the perceived degree of risk, which are applied to certain financial balances and financial activity. The adequacy of a company’s actual capital is evaluated by a comparison to the RBC results, as determined by the formula. Companies that do not maintain statutory capital and surplus at a level in excess of the company action level RBC are required to take specified actions. At December 31, 2017 and 2016, actual statutory capital and surplus for Kinsale Insurance substantially exceeded the regulatory requirements.
Dividend payments to Kinsale from Kinsale Insurance are restricted by state insurance laws as to the amount that may be paid without prior approval of the regulatory authorities of Arkansas. The maximum dividend distribution is limited by Arkansas law to the greater of 10% of policyholder surplus as of December 31 of the previous year or net income, not including realized capital gains, for the previous calendar year. Dividend payments are further limited to that part of available policyholder surplus which is derived from net profits on its business. The maximum dividend distribution that can be paid by Kinsale Insurance during 2018 without prior approval is $23.7 million.
Kinsale Capital Group, Inc., a Delaware domiciled insurance holding company, was formed on June 3, 2009 for the purpose of acquiring and managing insurance entities.