Our principal executive offices are currently located at 1154 Broadway, Hewlett, New York. Our insurance underwriting business is located principally at 15 Joys Lane, Kingston, New York.
We derive 99% 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. All of our policies are for a one year period. 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 one year 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.
Depreciation and amortization. Depreciation and amortization includes the amortization of intangibles related to the acquisition of KICO, depreciation of the office building used in KICO’s operations, as well as depreciation of office equipment and furniture.
Net underwriting expense ratio. The net underwriting expense ratio is a measure of an insurance company’s operational efficiency in administering its business. Expressed as a percentage, this is the ratio of the sum of acquisition costs (the most significant being commissions paid to our producers) and other underwriting expenses less ceding commission revenue less other income to net premiums earned.
Net combined ratio. The net combined ratio is a measure of an insurance company’s overall underwriting profit. This is the sum of the net loss and net underwriting expense ratios. If the net combined ratio is at or above 100 percent, an insurance company cannot be profitable without investment income, and may not be profitable if investment income is insufficient.
Direct written premiums during the year ended December 31, 2012 (“2012”) were $49,252,000 compared to $40,735,000 during the year ended December 31, 2011 (“2011”). The increase of $8,517,000, or 20.9%, was primarily due to an increase in policies in-force during 2012 as compared to 2011. We wrote more policies as a result of an increase in demand for the products in the markets that we serve. Policies in-force increased by 20.9% as of December 31, 2012 compared to December 31, 2011. In addition to the increase of policies in-force, we are also writing more policies which have higher premiums.
Net written premiums increased $3,264,000, or 20.0%, to $19,560,000 in 2012 from $16,296,000 in 2011. The increase in net written premiums resulted from: (1) an increase in direct written premiums in 2012 compared to direct written premiums in 2011, and (2) effective July 1, 2012, a decrease in the quota share percentage in our commercial lines quota share treaty from 60% to 40%. A decrease in the quota share percentage results in us retaining a greater amount of direct written premiums. Net written premiums grew at a lower rate than direct written premiums (20.0% compared to 20.9%) due to increases in policies written in lines of business that are subject to quota share reinsurance treaties, primarily personal lines and commercial lines, in excess of the decrease in policies written in lines of business without quota share reinsurance treaties, primarily commercial auto lines.
Other operating expenses, related to the corporate expenses of our holding company, were $1,000,000 in 2012 compared to $1,203,000 in 2011. The $203,000 decrease in 2012, or 16.9%, was primarily due to decreases in executive bonuses, occupancy costs, professional fees, and amortization of stock options as a result of more stock options being fully vested prior to 2012.
Interest expense was $82,000 in 2012 compared to $121,000 in 2011. The $39,000 decrease in interest expense, or 32.2%, was due to the partial redemption of $703,000 of our 2009/2010 Notes during the quarter ended September 30, 2011, and effective July 11, 2011, a reduction in the interest rate to 9.5% per annum from the previous 12.625% per annum. The decrease in interest expense from our 2009/2010 Notes was offset by $11,000 of interest paid on our bank line of credit which was opened in December 2011.
Our insurance underwriting business reported on a standalone basis for the years ended December 31, 2012 and 2011 follows:
The effect of catastrophes by line of business on our net premiums earned and our direct, ceded and net loss and loss adjustment expenses included in our results of operations for the years ended December 31, 2012 and 2011 follows:
(2) Includes (a) the sum of direct catastrophe losses and loss adjustment expenses and (b) the sum of net catastrophe losses and loss adjustment expenses of $13,260,964 and $1,143,022, respectively, for the year ended December 31, 2012. Includes (x) the sum of direct catastrophe losses and loss adjustment expenses and (y) the sum of net catastrophe losses and loss adjustment expenses of $1,796,117 and $449,029, respectively, for the year ended December 31, 2011.
All held to maturity securities are held in trust pursuant to the New York State Department of Financial Services’ minimum funds requirement.
Contractual maturities of all held to maturity securities are greater than ten years.
The table below summarizes the credit quality of our available for sale fixed-maturity securities as of December 31, 2012 and 2011 as rated by Standard and Poor’s:
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, 2012 and 2011:
On July 1, 2009, we completed the acquisition of 100% of the issued and outstanding common stock of KICO (formerly known as Commercial Mutual Insurance Company (“CMIC”)) pursuant to the conversion of CMIC from an advance premium cooperative to a stock property and casualty insurance company. Pursuant to the plan of conversion, we acquired a 100% equity interest in KICO. In connection with the plan of conversion of CMIC, we agreed with the Department of Financial Services (formerly known as the Insurance Department) (the “Department”) that, for a period of two years following the effective date of conversion of July 1, 2009, no dividend could be paid by KICO to us without the approval of the Department (“Dividend Restriction Period”). No such request was made by us to the Department within the Dividend Restriction Period. For year ended December 31, 2012, KICO paid dividends of $700,000 to us. We also agreed with the Department that certain intercompany transactions between KICO and us must be filed with the Department 30 days prior to implementation and not disapproved by the Department.
In December 2011, we entered into an agreement with a bank for a $500,000 line of credit to be used for general corporate needs. In January 2013, the line of credit was increased to $600,000. The principal balance is payable on demand, and must be reduced to zero for a minimum of 30 consecutive days during each year of the term of the credit line. The principal balance was reduced to zero in accordance with the terms of the credit line in 2012. The outstanding balance was $450,000 as of December 31, 2012. On March 6, 2013, the line of credit, which had an outstanding balance of $550,000, was paid in full. If the aforementioned is insufficient to cover our holding company cash requirements, we will seek to obtain additional financing.
Our reconciliation of net income to cash provided by operations is generally influenced by the collection of premiums in advance of paid losses, the timing of reinsurance, issuing company settlements and loss payments.
The primary location of KICO’s insureds is in the New York City area, which was struck by Superstorm Sandy on October 29, 2012. KICO purchases quota share and catastrophe reinsurance in order to reduce its net liability on insurance risks and to protect against catastrophes. KICO’s personal lines business, which includes homeowners insurance, is reinsured under a 75% quota share treaty and catastrophe insurance pursuant to which KICO’s net liability is limited to 25% of the initial $3,000,000 of direct losses incurred from a catastrophe occurrence, or $750,000. For catastrophe losses in excess of $3,000,000, KICO is 100% covered by catastrophe reinsurance with regard to the next $70,000,000 in losses. As of December 31, 2012, KICO’s net loss incurred as a result of the storm was $750,000 with respect to KICO’s personal lines business, which is the limit of loss pursuant to its quota share and catastrophe reinsurance treaties. Additional net losses of $393,000 were incurred with respect to KICO’s business owners, commercial auto and livery physical damage policies. We were also required to pay $77,000 of reinstatement premiums to catastrophe reinsurers to obtain coverage for future catastrophe events during the current reinsurance treaty period.
The following table summarizes 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, 2012:
Personal umbrella policies are reinsured under a 90% quota share treaty which provides coverage with respect to losses of up to $1,000,000 per occurrence. The second $1,000,000 of coverage is 100% reinsured.
General liability commercial policies written by us, except for commercial auto policies, are reinsured under a 40% quota share treaty, which provides coverage with respect to losses of up to $500,000 per occurrence. Excess of loss contracts provide 100% of coverage for the next $2,400,000 of losses for a total reinsurance coverage of $2,600,000 with respect to losses of up to $2,900,000 per occurrence.
Commercial auto policies are covered by an excess of loss reinsurance contract which provides $1,750,000 of coverage in excess of $250,000.
Our reinsurance program is structured to reflect our obligations and goals. Reinsurance via quota share allows for a carrier to write business without increasing its leverage above a management determined ratio. The additional business written allows a reinsurer to assume the risks involved, but gives the reinsurer much of the profit (or loss) associated with such. We have determined it to be in the best interests of our shareholders to prudently reduce our reliance on quota share reinsurance. Any such reduction would result in higher earned premiums and a reduction in ceding commission revenue in future years. Our participation in reinsurance arrangements do not relieve us of our obligations to policyholders.
As a property and casualty insurer, we may face significant losses from catastrophes and severe weather events.
Because of the exposure of our property and casualty business to catastrophic events (such as Superstorm Sandy as discussed below), 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.
The capital and credit markets have been experiencing extreme volatility and disruption. In some cases, the markets have exerted downward pressure on the availability of liquidity and credit capacity. In the event that we need access to additional capital to pay our operating expenses, make payments on our indebtedness, pay for capital expenditures or increase the amount of insurance that we seek to underwrite, our ability to obtain such capital may be limited and the cost of any such capital may be significant. Our access to additional financing will depend on a variety of factors, such as market conditions, the general availability of credit, the overall availability of credit to our industry, our credit ratings and credit capacity as well as lenders' perception of our long or short-term financial prospects. Similarly, our access to funds may be impaired if regulatory authorities or rating agencies take negative actions against us. If a combination of these factors occurs, our internal sources of liquidity may prove to be insufficient and, in such case, we may not be able to successfully obtain additional financing on favorable terms.
The effects of Superstorm Sandy will be material to our post-2012 results of operations.
On October 29, 2012, the New York City area, which is the primary location of KICO’s insureds, was struck by Superstorm Sandy. Certain material effects of the storm on our post-2012 results of operations are described under “Liquidity and Capital Resources - Superstorm Sandy” above. Given the reinsurance losses that were incurred as a result of the storm, it is possible that the terms and conditions for any reinsurance that we may require following the end of our current reinsurance treaties on June 30, 2013 will be materially impacted.
Substantially all of our revenue is currently derived from sources located in the state of New York and, accordingly, is affected by the prevailing regulatory, economic, demographic, competitive and other conditions in such state. Changes in any of these conditions could make it more costly or difficult for us to conduct our business. Adverse regulatory developments in New York, which could include fundamental changes to the design or implementation of the insurance regulatory framework, could have a material adverse effect on our results of operations and financial condition.
Recorded claim reserves in our business are based on our best estimates of losses after considering known facts and interpretations of circumstances. Internal and external factors are considered. Internal factors include, but are not limited to, actual claims paid, pending levels of unpaid claims, product mix and contractual terms. External factors include, but are not limited to, changes in the law, court decisions, changes in regulatory requirements and economic conditions. Because reserves are estimates of the unpaid portion of losses that have occurred, the establishment of appropriate reserves, including reserves for catastrophes, is an inherently uncertain and complex process. The ultimate cost of losses may vary materially from recorded reserves, and such variance may adversely affect our operating results and financial condition.
Regulations requiring us to underwrite business and participate in loss sharing arrangements may adversely affect our operating results and financial condition.
The state of New York has enacted laws that require a property liability insurer conducting business in such state to participate in assigned risk plans, reinsurance facilities and joint underwriting associations or require the insurer to offer coverage to all consumers, often restricting an insurer's ability to charge the price it might otherwise charge. In these markets, we may be compelled to underwrite significant amounts of business at lower than desired rates, possibly leading to an unacceptable return on equity, which may adversely affect our operating results and financial condition.
Our future success will depend, in part, upon the efforts of Barry Goldstein, our President and Chief Executive Officer, and John Reiersen, who currently serves as Executive Vice President of KICO and, until January 1, 2012, served as President and Chief Executive Officer of KICO. The loss of Messrs. Goldstein and/or Reiersen or other key personnel could prevent us from fully implementing our business strategies and could materially and adversely affect our business, financial condition and results of operations. As we continue to grow, we will need to recruit and retain additional qualified management personnel, but we may not be able to do so. Our ability to recruit and retain such personnel will depend upon a number of factors, such as our results of operations and prospects and the level of competition then prevailing in the market for qualified personnel. Effective January 1, 2012, Mr. Reiersen became Executive Vice President of KICO and provides, in a part-time capacity, advice and assistance to the President and Chief Executive Officer of KICO, and other management personnel, with regard to the management and operation of KICO. Mr. Goldstein assumed the duties and responsibilities of President and Chief Executive Officer of KICO effective January 1, 2012. Although Mr. Goldstein has served as our President and Chief Executive Officer since 2001, as KICO’s Chairman of the Board and Chairman of the Executive Committee since 2006 and as KICO’s Chief Investment Officer since 2008, prior to January 1, 2012, he had never served as President and Chief Executive Officer of an insurance company.
Some economists continue to project significant negative macroeconomic trends, including relatively high and sustained unemployment, reduced consumer spending, and substantial increases in delinquencies on consumer debt, including defaults on home mortgages. Moreover, recent disruptions in the financial markets, particularly the reduced availability of credit and tightened lending requirements, have impacted the ability of borrowers to refinance loans at more affordable rates. As with most businesses, we believe that difficult conditions in the economy could have an adverse effect on our business and operating results. General economic conditions also could adversely affect us in the form of consumer behavior, which may include decreased demand for our products. As consumers become more cost conscious, they may choose lower levels of insurance.