Our expenses include the insurance underwriting expenses of KICO and other operating expenses. Insurance companies incur a significant amount of their total expenses from losses incurred by policyholders, which are commonly referred to as claims. In settling these claims, various loss adjustment expenses (“LAE”) are incurred such as insurance adjusters’ fees and legal expenses. In addition, insurance companies incur policy acquisition costs. Policy acquisition costs include commissions paid to producers, premium taxes, and other expenses related to the underwriting process, including employees’ compensation and benefits.
Net investment income and net gains (losses) on investments: We invest in cash and cash equivalents, short-term investments, fixed-maturity and equity securities. Our net investment income includes interest and dividends earned on our invested assets, less investment expenses. Net realized gains and losses on our investments are reported separately from our net investment income. Net realized gains occur when our investment securities are sold for more than their costs or amortized costs, as applicable. Net realized losses occur when our investment securities are sold for less than their costs or amortized costs, as applicable, or are written down as a result of other-than-temporary impairment. We classify our fixed-maturity securities as either available-for-sale or held-to-maturity. Net unrealized gains (losses) on those securities classified as available-for-sale are reported separately within accumulated other comprehensive income on our balance sheet while our equity securities and other investments report changes in fair value through earnings. See Note 2 in the accompanying Consolidated Financial Statements for further discussion over our accounting policies following Item 15 of this Annual Report.
Other income: We recognize installment fee income and fees charged to reinstate a policy after it has been cancelled for non-payment.
Stock-based compensation: Non-cash equity compensation includes the fair value of stock grants issued to our directors, officers and employees, and amortization of stock options issued to the same.
Interest expense: Interest expense represents amounts we incur on our outstanding indebtedness at the applicable interest rates. Interest expense also includes amortization of debt discount and issuance costs.
We offer businessowners policies, which consist primarily of small business retail, service, and office risks, with limited residential exposure. We also write artisan’s liability policies for small independent contractors with smaller sized workforces. In addition, we write special multi-peril policies for larger and more specialized businessowners risks, including those with limited residential exposures. Further, we offer commercial umbrella policies written above our supporting commercial lines policies.
Livery physical damage: We write for-hire vehicle physical damage only policies for livery and car service vehicles and taxicabs. These policies insure only the physical damage portion of insurance for such vehicles, with no liability coverage included.
We believe that the most critical accounting policies relate to the reporting of reserves for loss and LAE, including losses that have occurred but have not been reported prior to the reporting date, amounts recoverable from third party reinsurers, deferred ceding commission revenue, deferred policy acquisition costs, deferred income taxes, the impairment of investment securities, intangible assets and the valuation of stock-based compensation. See Note 2 (Summary Significant Accounting Policies) of the Notes to Consolidated Financial Statements following Item 15 of this Annual Report.
Overall, we are pleased with our continuing year over year growth. We anticipate launching homeowners products in Connecticut and Maine during 2019, which will add to our already expanding market share in the Northeast.
Turning to 2019 expectations: Based on our current view of the marketplace, we expect the following:
(1) Effective July 1, 2018, we decreased the quota share ceding rate in our personal lines quota share treaty from 20% to 10% (the “2018 cut-off”). The 2018 cut-off resulted in an approximately $4,553,000 return of unearned premiums from our reinsurers that were previously ceded under the expiring personal lines quota share treaty. Effective July 1, 2017, we decreased the quota share ceding rate in our personal lines quota share treaty from 40% to 20% (the “2017 cut-off”). The 2017 cut-off resulted in an approximately $7,140,000 return of unearned premiums from our reinsurers that were previously ceded under the expiring personal lines quota share treaty.
(2) The year ended December 31, 2018 includes catastrophe losses, which are defined as losses from an event for which a catastrophe bulletin and related serial number has been issued by the Property Claims Services (PCS) unit of the Insurance Services Office (ISO). PCS catastrophe bulletins are issued for events that cause more than $25 million in total insured losses and affect a significant number of policyholders and insurers.
The following table describes the quota share reinsurance ceding rates in effect during Year Ended 2018 and Year Ended 2017, respectively. This table should be referred to in conjunction with the discussions for net written premiums, net premiums earned, ceding commission revenue and net loss and loss adjustment expenses that follow.
Net written premiums increased $26,925,000, or 29.0%, to $119,794,000 in Year Ended 2018 from $92,869,000 in Year Ended 2017. Net written premiums include direct and assumed premiums, less the amount of written premiums ceded under our reinsurance treaties (quota share, excess of loss, and catastrophe). Our personal lines business is currently subject to a quota share treaty. A reduction to the quota share percentage or elimination of a quota share treaty will reduce our ceded written premiums, which will result in a corresponding increase to our net written premiums. The increase in net written premiums is due to growth and the reductions of our personal lines quota share reinsurance rate to 20% and 10% on July 1, 2017 and July 1, 2018, respectively.
Effective July 1, 2018, we decreased the quota share ceding rate in our personal lines quota share treaty from 20% to 10%. The Cut-off of this treaty on July 1, 2018 resulted in a $4,553,000 return of unearned premiums from our reinsurers that were previously ceded under the expiring personal lines quota share treaty. Our quota share ceding rate changed from 40% to 20% in Year Ended 2017 resulting in a $7,140,000 return of unearned premiums from our reinsurers that were previously ceded. The table below shows the effect of the $4,553,000 and $7,140,000 return of ceded premiums on net written premiums for Year Ended 2018 and Year Ended 2017, respectively:
Net premiums earned increased $26,064,000, or 33.7%, to $103,415,000 in Year Ended 2018 from $77,351,000 in Year Ended 2017. The increase was due to the increase in written premiums discussed above and our retaining more earned premiums effective July 1, 2017 and 2018, as a result of the reductions of the quota share percentage in our personal lines quota share treaties.
We receive a provisional ceding commission based on ceded written premiums. The $3,931,000 decrease in provisional ceding commissions earned is primarily due to the decreases in the quota share ceding rate: (1) effective July 1, 2018 to 10%, from the 20% rate in effect from July 1, 2017 through June 30, 2018, and (2) effective July 1, 2017 to 20%, from the 40% rate in effect from January 1, 2017 through June 30, 2017; thus there were fewer ceded premiums in 2018 available to earn ceding commissions than there were in 2017. The decrease was partially offset by an increase in personal lines direct written premiums subject to the quota share and by the one percentage point increase in our provisional ceding commission rate as disclosed in the table above.
We receive a contingent ceding commission based on a sliding scale in relation to the losses incurred under our quota share treaties. The lower the ceded loss ratio, the more contingent commission we receive. The amount of contingent ceding commissions we are eligible to receive under the 2017/2019 Treaty is subject to change based on losses incurred from claims with accident dates beginning July 1, 2017. The amount of contingent ceding commissions we are eligible to receive under our prior years’ quota share treaties is subject to change based on losses incurred related to claims with accident dates before July 1, 2017.
Cash and invested assets were $195,567,000 as of December 31, 2018, compared to $187,526,000 as of December 31, 2017. The $8,041,000 increase in cash and invested assets resulted primarily from increased operating cash flows for the year ended December 31, 2018.
Net losses on investments were $2,496,000 in Year Ended 2018 compared to a net gain of $84,000 in Year Ended 2017. The increased loss of $2,580,000, was primarily attributable to an accounting standard change (ASU 2016-01, see Note 2 in the accompanying Consolidated Financial Statements for further discussion over our accounting policies following Item 15 of this Annual Report) with respect to the changes in fair value of equity securities and other investments. Historically, the change in unrealized gains (losses) for these investments would flow through other comprehensive (loss) income. As a result of the new accounting standard, the change in unrealized gains (losses) is now recorded in the statements of income and comprehensive (loss) income. Unrealized losses on our equity securities and other investments in Year Ended 2018 were $2,383,000. Realized losses on investments was $56,000 in Year Ended 2018 compared to realized gains of $84,000 in Year Ended 2017.
Other income was $1,334,000 in Year Ended 2018 compared to $1,268,000 in Year Ended 2017. The increase of $66,000, or 5.2%, was primarily due to an increase in installment and other fees earned in our insurance underwriting business.
Net loss and LAE was $52,068,000 in Year Ended 2018 compared to $34,186,000 in Year Ended 2017. The net loss ratio was 56.4% in Year Ended 2018 compared to 44.2% in Year Ended 2017, an increase of 12.2 percentage points.
Commission expense was $25,342,000 in 2018 or 19.0% of direct earned premiums. Commission expense was $21,182,000 in 2017 or 19.1% of direct earned premiums. The increase of $4,160,000 is due to the increase in direct written premiums in 2018 as compared to 2017.
Other underwriting expenses were $20,943,000 in Year Ended 2018 compared to $18,116,000 in Year Ended 2017. The increase of $2,827,000, or 15.6%, was primarily due to expenses related to growth in direct written premiums. We are also incurring expenses related to expansion into the states where we are newly licensed to write business (“Expansion Expenses”). Expenses directly related to the increase in direct written premiums primarily consist of underwriting expenses, software usage fees, and state premium taxes. Expenses indirectly related to the increase in direct written premiums primarily consist of salaries along with related other employment costs. Expansion Expenses were $1,653,000 in Year Ended 2018 compared to $1,044,000 in Year Ended 2017. The increase of $619,000 includes the costs of salaries and employment costs, professional fees, IT and data services specifically attributable to the expansion into new states.
Core salaries and employment costs were $8,444,000 in Year Ended 2018 compared to $7,385,000 in Year Ended 2017. The increase of $1,059,000, or 14.3%, was less than the 20.7% increase in total direct written premiums. The increase in employment costs was due to hiring of additional staff to service our current level of business and anticipated growth in volume, hiring our new Chief Operating Officer in March 2018 (Chief Executive Officer effective January 1, 2019) as well as annual increases in salaries. Growth related to our Expansion business creates a lag in net premiums earned compared to direct written premiums for that business. This lag in net premiums earned along with the reduction to quota share rates distorts net underwriting expense ratio comparisons between periods. Therefore, we believe that reviewing the ratio of Core other underwriting expenses to Core net premiums earned offers a more consistent comparison between periods and is a more accurate indicator of our overall other underwriting expense efficiency. The following table breaks out the Core and Expansion components of our underwriting expense ratio for the periods indicated:
Our net underwriting expense ratio in Year Ended 2018 was 38.4% compared with 36.4% in Year Ended 2017. The following table shows the individual components of our net underwriting expense ratio for the periods indicated:
Other operating expenses, related to the expenses of our holding company, were $2,575,000 in Year Ended 2018 compared to $3,513,000 in Year Ended 2018. The decrease in Year Ended 2018 of $938,000, or 26.7%, was primarily due to a decrease in accrued executive bonus compensation pursuant to the employment agreement effective January 1, 2017 with Barry B. Goldstein, our Chief Executive Officer. The bonus is a one-time payment computed at the end of the three-year period ended December 31, 2019, and the amount accrued through December 31, 2018 will only be paid if the three-year computation meets the required terms of profitability. The decrease in executive bonus computation was partially offset by an increase in salary and equity compensation due to the hiring of Dale A. Thatcher, our new Chief Operating Officer, in March 2018 (Chief Executive Officer effective January 1, 2019).
Our insurance underwriting business reported on a standalone basis for the years ended December 31, 2018 and 2017 follows:
(1) In 2017, KICO placed certain residential mortgage backed securities as eligible collateral in a designated custodian account related to its relationship with the Federal Home Loan Bank of New York ("FHLBNY"). The eligible collateral would be pledged to FHLBNY if KICO draws an advance from FHBLNY. As of December 31, 2018, the estimated fair value of the eligible investments was $5,116,000. KICO will retain all rights regarding all securities if pledged as collateral. As of December 31, 2018, there was no outstanding balance on the FHLBNY credit line.
Pursuant to the definition of “Fair Value Measurement,” set forth in the Accounting Standards Codification 820 (the “ASC 820”) an entity is permitted, as a practical expedient, to estimate the fair value of an investment within the scope of ASC 820 using the net asset value (“NAV”) per share (or its equivalent) of the investment. The following table presents a breakdown of the cost, estimated fair value, and gross losses of our other investments as of December 31, 2018 and 2017:
A summary of the amortized cost and fair value of our investments in held-to-maturity securities by contractual maturity as of December 31, 2018 and 2017 is shown below:
The table below details the average yield by type of fixed-maturity security as of December 31, 2018 and 2017:
As more fully described in Note 3 to our Consolidated Financial Statements, “Investments-Impairment Review,” we completed a detailed review of all our securities in a continuous loss position as of December 31, 2018 and December 31, 2017. In December, 2017, we disposed of one of our held-to-maturity debt securities that was previously included in other than temporary impairment (“OTTI”); the bond was issued by the Commonwealth of Puerto Rico (“PR”). In July 2016, PR defaulted on its interest payment to bondholders. Due to the credit deterioration of PR, we recorded our first credit loss component of OTTI on this investment as of June 30, 2016. As of December 31, 2016, the full amount of the write-down was recognized as a credit component of OTTI in the amount of $69,911. In September 2017, Hurricane Maria significantly affected Puerto Rico. The impact of this event further contributed to the credit deterioration of PR and, as a result, we recorded an additional credit loss component of OTTI on this investment for the amount of $50,000 during the quarter ended September 30, 2017. The total of the two OTTI write-downs of this investment as of December 31, 2017 was $119,911. We determined that none of the other unrealized losses were deemed to be OTTI for our portfolio of fixed-maturity investments and equity securities for the years ended December 31, 2018 and 2017. 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 and ability to retain the investment for a period of time sufficient to allow for an anticipated recovery of fair value to our cost basis.
The table below summarizes the gross unrealized losses of our fixed-maturity securities available-for-sale and equity securities by length of time the security has continuously been in an unrealized loss position as of December 31, 2018 and 2017:
On January 31, 2017, we closed on an underwritten public offering of 2,500,000 shares of our common stock. On February 14, 2017, we closed on the underwriters’ purchase option for an additional 192,500 shares of our common stock. The public offering price for the 2,692,500 shares sold was $12.00 per share. The aggregate net proceeds to us were approximately $30,137,000. On March 1, 2017, we used $23,000,000 of the net proceeds of the offering to contribute capital to KICO, to support its ratings upgrade plan and additional growth. The remainder of the net proceeds will be used for general corporate purposes.
KICO is a member of the Federal Home Loan Bank of New York, which provides additional access to liquidity. Members have access to a variety of flexible, low cost funding through FHLBNY’s credit products, enabling members to customize advances. Advances are to be fully collateralized; eligible collateral to pledge to FHLBNY includes residential and commercial mortgage backed securities, along with U.S. Treasury and agency securities. See Note 3 to our Consolidated Financial Statements, - “Investments”, for eligible collateral held in a designated custodian account available for future advances. Advances are limited to 5% of KICO’s net admitted assets as of December 31, 2018 and are due and payable within one year of borrowing. The maximum allowable advance as of December 31, 2018, based on the net admitted assets as of December 31, 2018, was approximately $10,960,000. Advances are limited to the amount of available collateral, which was approximately $5,116,000 as of December 31, 2018. There were no borrowings under this facility during the year ended December 31, 2018.
The following table provides summary information with respect to each reinsurer that accounted for more than 10% of our reinsurance recoverables on paid and unpaid losses and loss adjustment expenses as of December 31, 2018:
In March 2017, we bound our personal lines quota share reinsurance treaty effective July 1, 2017. The treaty provides for a reduction in the quota share ceding rate to 20%, from 40% in the 2016/2017 Treaty, and an increase in the provisional ceding commission rate to 53%, from 52% in the 2016/2017 Treaty. The 2017/2019 Treaty covers a two year period from July 1, 2017 through June 30, 2019. In August 2018, we reduced our quota share ceding rate under the 2017/2019 Treaty to 10%, from 20%, effective July 1, 2018.
For personal lines, the 2017/2019 Treaty includes the addition of an automatic facultative facility allowing KICO to obtain homeowners single risk coverage up to $10,000,000 in total insured value, which covers direct losses from $3,500,000 to $10,000,000.
Effective July 1, 2018, the top $50,000,000 layer of catastrophe reinsurance coverage has a two-year term expiring on June 30, 2020.
Effective July 1, 2018, reinstatement premium protection for $210,000,000 of catastrophe coverage in excess of $5,000,000.
The single maximum risks per occurrence to which the Company is subject under the treaties effective July 1, 2018 are as follows:
Treaty for July 1, 2017 - June 30, 2018 is a two-year treaty with expiration date of June 30, 2019.