Our principal executive offices are currently located at 15 Joys Lane, Kingston, New York 12401. Our insurance underwriting business is located principally at 15 Joys Lane, Kingston, New York 12401. Our insurance underwriting business also maintains an executive office located at 70 East Sunrise Highway, Valley Stream, New York 11581, at which we lease 3,250 square feet of space.
Net premiums earned. Net premiums earned is the earned portion of our written premiums, less that portion of premium that is ceded to third party reinsurers under reinsurance agreements. The amount ceded under these reinsurance agreements is based on a contractual formula contained in the individual reinsurance agreement. Insurance premiums are earned on a pro rata basis over the term of the policy. At the end of each reporting period, premiums written that are not earned are classified as unearned premiums and are earned in subsequent periods over the remaining term of the policy. Our insurance policies have a term of one year. Accordingly, for a one-year policy written on July 1, 2014, we would earn half of the premiums in 2014 and the other half in 2015.
Other income. We recognize installment fee income and fees charged to reinstate a policy after it has been cancelled for non-payment. Through March 31, 2015, we also recognized premium finance fee income on loans financed by a third party finance company.
Commercial automobile: Until recently we provided liability and physical damage coverage for light vehicles owned by small contractors and artisans. However, due to the poor performance of this line, effective October 1, 2014, we decided to no longer accept new commercial auto policies. In February 2015, we decided to no longer offer renewals to our existing commercial auto policies beginning with those that expired on or after May 1, 2015.
Our growth rate in direct premiums written was dampened somewhat due to the cessation, effective October 1, 2014, of the writing of new policies in our commercial auto line of business due to a history of poor underwriting results. In February 2015, we made the decision to no longer offer renewals on our existing commercial auto policies beginning with those that expire on or after May 1, 2015.
Our direct written premiums in our other lines of business grew by 23.9% in 2015 compared to 2014. Policies-in-force in our other lines of business increased by 19.5% as of December 31, 2015 compared to December 31, 2014.
The following table describes the quota share reinsurance ceding rates in effect during 2015 and 2014. For purposes of the discussion herein, the change in quota share ceding rates on July 1 of each year will be referred to as “the Cut-off”. 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.
Effective July 1, 2015, we decreased the quota share ceding rate in our personal lines quota share treaty from 55% to 40%. The Cut-off of this treaty on July 1, 2015 resulted in a $5,866,000 return of unearned premiums from our reinsurers that were previously ceded under the expiring personal lines quota share treaty. The new treaty is on a “net” of catastrophe reinsurance basis, as opposed to the “gross” arrangement that existed in prior years. Under a “net” arrangement, all catastrophe reinsurance coverage is now purchased directly by us.
Net premiums earned increased $15,984,000, or 49.0%, to $48,612,000 in 2015 from $32,628,000 in 2014. The increase was primarily due to us retaining more earned premiums as result of the reduction of the quota share percentage in our personal lines quota share treaty and the elimination of the commercial lines treaty on July 1, 2014. The decreases in our quota share ceding percentages from the July 1, 2015 and 2014 Cut-offs gave us a return of premiums previously ceded, which increases our net premiums earned during the twelve month periods after the Cut-offs. In addition, as premiums written earn ratably over a twelve month period, net premiums earned in 2015 increased due to the higher net written premiums generated for the twelve months ended December 31, 2015 compared to the twelve months ended December 31, 2014.
The following table summarizes the changes in the components of ceding commission revenue (in thousands) for the periods indicated:
Ceding commission revenue was $11,473,000 in 2015 compared to $13,910,000 in 2014. The decrease of $2,437,000, or 17.5%, was due to a decrease in provisional ceding commissions earned and a decrease in contingent ceding commissions earned.
We receive a provisional ceding commission based on ceded written premiums. Under the terms of the 2015/2016 Treaty, the provisional ceding commission rate increased to 55% from 40% under the 2014/2015 Treaty. Provisional ceding commission earned was $11,692,000 in 2015 compared to $12,456,000 in 2014. The decrease of $764,000, or 6.1%, in provisional ceding commissions earned is due to: (1) a decrease in the amount of premiums subject to provisional ceding commissions, (2) a decrease in the percentage of ceded premiums subject to quota share under the “net” 2015/2016 Treaty compared to the “gross” 2014/2015 Treaty, and (3) partially offset by the increase in the provisional ceding commission rates under the 2015/2016 Treaty.
As a result of the increase in the provisional ceding commission rate to 55% under the 2015/2016 Treaty from 40% under the 2014/2015 Treaty, we do not have an opportunity to earn as much contingent ceding commissions. Under the “net” treaty in effect as of July 1, 2015, catastrophe losses in excess of the first $4,000,000 will fall outside of the quota share treaty and such losses will not have an impact on contingent ceding commissions, as was the case under previous “gross” treaties. The new structure eliminates the adverse impact that catastrophe losses above $4,000,000 would have on contingent ceding commissions.
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 two personal lines quota share treaties described in the table above that were in effect during 2015 are subject to change based on losses incurred from claims with accident dates beginning July 1, 2014. 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, 2014 under those treaties. In addition, our total ceding contingent commission revenue was reduced in 2015 due to us not renewing our commercial lines quota share treaty upon its expiration on June 30, 2014.
Other income was $1,577,000 in 2015 compared to $1,006,000 in 2014. The increase of $571,000, or 56.8%, was primarily due to the $350,000 we received as early settlement of the termination agreement that generated placement fees in our premium finance business (see Note 19 to the Consolidated Financial Statements).
Commission expense was $15,317,000 in 2015 or 18.9% of direct earned premiums. Commission expense was $12,125,000 in 2014 or 17.8% of direct earned premiums. The increase of $3,192,000, or 26.3%, is due to the increase in direct written premiums in 2015 as compared to 2014 and a change in the mix of business to lines of business with higher commission rates, and an increase in bonus commissions.
Our net underwriting expense ratio in 2015 was 32.3% compared with 24.9% in 2014. The following table shows the individual components of our net underwriting expense ratio for the periods indicated:
The increase of 7.4 percentage points was due to the individual components of provisional ceding commission revenue, commission expense and other underwriting expenses and their relation to the increase in net premiums earned as a result of the additional retention resulting from the Cut-offs to our quota share treaties on July 1, 2015.
Other operating expenses, related to the expenses of our holding company, were $1,504,000 in 2015 compared to $1,487,000 in 2014. The increase in 2015 of $17,000, or 1.1%, was composed of nominal increases and decreases in the various expenses that are included in other operating expenses.
Depreciation and amortization was $1,032,000 in 2015 compared to $875,000 in 2014. The increase of $157,000, or 17.9%, in depreciation and amortization was primarily due to depreciation on newly purchased assets used to upgrade our systems infrastructure and the Kingston, New York home office building from which we operate.
Income tax expense in 2015 was $3,349,000, which resulted in an effective tax rate of 32.5%. Income tax expense in 2014 was $2,547,000, which resulted in an effective tax rate of 32.3%. Income before taxes was $10,309,000 in 2015 compared to $7,875,000 in 2014. The increase in the effective tax rate by 0.2 percentage points in 2015 is a result of the change in the enacted state tax rate resulting in a current period decrease in the deferred tax benefit of our state net operating losses, net of the corresponding valuation adjustment. This increase was partially offset by the benefits of permanent differences generated from investment income as a result of the increase in our invested assets.
Net income was $6,960,000 in 2015 compared to $5,328,000 in 2014. The increase in net income of $1,632,000, or 30.6%, was due to the circumstances described above that caused the increase in our net premiums earned, net investment income, and other income, and a decrease in our net loss ratio, partially offset by a decrease in net realized gains and ceding commission revenue, and increases in other underwriting expenses related to premium growth and other operating expenses.
“Other” includes, among other things, premiums and loss and loss adjustment expenses from our participation in mandatory state joint underwriting associations.
Our insurance underwriting business reported on a standalone basis for the years ended December 31, 2015 and 2014 follows:
(1) For the year ended December 31, 2015 and 2014, the effect of severe winter weather, defined as a catastrophe, reduced contingent ceding commission revenue by $1,280,521 and $517,269, respectively.
(2) For the year ended December 31, 2015 and 2014, includes the sum of net catastrophe losses and loss adjustment expenses of $2,090,593 and $941,027, respectively, resulting from severe winter weather.
The table below summarizes the credit quality of our available-for-sale fixed-maturity securities as of December 31, 2015 and 2014 as rated by Standard and Poor’s (or, if unavailable from Standard and Poor’s, then Moody’s or Fitch):
The table below details the average yield by type of fixed-maturity security as of December 31, 2015 and 2014:
The table below lists the weighted average maturity and effective duration in years on our fixed-maturity securities as of December 31, 2015 and 2014:
As disclosed in Note 4 to the Consolidated Financial Statements, with respect to “Fair Value Measurements,” we define fair value as the price that would be received to sell an asset or paid to transfer a liability in a transaction involving identical or comparable assets or liabilities between market participants (an “exit price”). The fair value hierarchy distinguishes between inputs based on market data from independent sources (“observable inputs”) and a reporting entity’s internal assumptions based upon the best information available when external market data is limited or unavailable (“unobservable inputs”). The fair value hierarchy prioritizes fair value measurements into three levels based on the nature of the inputs. Quoted prices in active markets for identical assets have the highest priority (“Level 1”), followed by observable inputs other than quoted prices including prices for similar but not identical assets or liabilities (“Level 2”), and unobservable inputs, including the reporting entity’s estimates of the assumption that market participants would use, having the lowest priority (“Level 3”). As of December 31, 2015 and 2014, 66% and 63%, respectively, of the investment portfolio recorded at fair value was priced based upon quoted market prices.
Net cash used in financing activities was $1,855,000 in 2015 compared to $1,350,000 used in 2014. The $505,000 increase in cash used in financing activities is the result of the $278,000 purchase of treasury stock in 2015, compared to $47,000 purchased in 2014, a $245,000 increase in dividends paid due to additional shares outstanding in 2015 and an increase in the dividend rate.
Our quota share reinsurance treaties are on a July 1 through June 30 treaty year basis; therefore, for year to date fiscal periods after June 30, two separate treaties will be included in such periods.
Our quota share reinsurance treaty in effect for the year ended December 31, 2015 for our personal lines business, which primarily consists of homeowners’ policies, was covered under the July 1, 2014/June 30, 2015 and July 1, 2015/June 30, 2016 treaty years. Our quota share reinsurance treaties in effect for the year ended December 31, 2014 for our personal lines business, which primarily consists of homeowners’ policies, was covered under the July 1, 2013/June 30, 2014 and July 1, 2014/June 30, 2015 treaty years. Our quota share reinsurance treaty in effect for the year ended December 31, 2014 for our commercial lines business was covered under the July 1, 2013/June 30, 2014 treaty year. We did not renew our expiring commercial lines quota share reinsurance treaty on July 1, 2014.
Catastrophe coverage is limited on an annual basis to two times the per occurrence amounts. Effective July 1, 2015, the duration of a catastrophe occurrence from windstorm, hail, tornado, hurricane and cyclone was extended to 120 consecutive hours from 96 consecutive hours.
Effective July 1, 2015, reinstatement premium protection for $16,000,000 of catastrophe coverage in excess of $4,000,000.
Because of the exposure of our property and casualty business to catastrophic events (such as Superstorm Sandy), 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, severe winter weather, storms and certain types of terrorism. We have catastrophe reinsurance coverage with regard to losses of up to $180,000,000. The initial $4,000,000 of losses in a catastrophe are subject to a 40% quota share reinsurance treaty, such that we retain $2,400,000 of risk per catastrophe occurrence. With respect to any additional catastrophe losses of up to $176,000,000, we are 100% reinsured under our catastrophe reinsurance program. Catastrophe coverage is limited on an annual basis to two times the per occurrence amounts. We may incur catastrophe losses in excess of: (i) those that we project would be incurred, (ii) those that external modeling firms estimate would be incurred, (iii) the average expected level used in pricing or (iv) 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. In addition, the reinsurance losses that are incurred in connection with a catastrophe could have an adverse impact on the terms and conditions of future reinsurance treaties.
Unanticipated increases in the severity or frequency of claims may adversely affect our operating results and financial condition.
Changes in the severity or frequency of claims may affect our profitability. Changes in homeowners claim severity are driven by inflation in the construction industry, in building materials and in home furnishings, and by other economic and environmental factors, including increased demand for services and supplies in areas affected by catastrophes. Changes in bodily injury claim severity are driven primarily by inflation in the medical sector of the economy and litigation. Changes in auto physical damage claim severity are driven primarily by inflation in auto repair costs, prices of auto parts and used car prices. However, changes in the level of the severity of claims are not limited to the effects of inflation and demand surge in these various sectors of the economy. Increases in claim severity can arise from unexpected events that are inherently difficult to predict, such as a change in the law or an inability to enforce exclusions and limitations contained in our policies. Although we pursue various loss management initiatives to mitigate future increases in claim severity, there can be no assurances that these initiatives will successfully identify or reduce the effect of future increases in claim severity, and a significant increase in claim frequency could have an adverse effect on our operating results and financial condition.
Applicable insurance laws regarding the change of control of our company may impede potential acquisitions that our shareholders might consider to be desirable.
The New York State Department of Financial Services imposes risk-based capital requirements on insurance companies to ensure that insurance companies maintain appropriate levels of surplus to support their overall business operations and to protect customers against adverse developments, after taking into account default, credit, underwriting, reserve and off-balance sheet risks. If the amount of our capital falls below this minimum, we may face restrictions with respect to soliciting new business and/or keeping existing business. Similar regulations will apply in other states in which we may operate.
In the aftermath of Superstorm Sandy, the New York State Department of Financial Services (the “DFS”) has adopted various regulations that affect insurance companies that operate in the state of New York. Included among the regulations are accelerated claims investigation and settlement requirements and mandatory participation in non-binding mediation proceedings funded by the insurer. In addition, in February 2013, the state of New York announced that the DFS has commenced an investigation into the claims practices of three insurance companies, including KICO, in connection with Superstorm Sandy claims. The DFS stated that the three insurers had a much larger than average consumer complaint rate with regard to Superstorm Sandy claims and indicated that the three insurers were being investigated for (i) failure to send adjusters in a timely manner; (ii) failure to process claims in a timely manner; and (iii) inability of homeowners to contact insurance company representatives. KICO received a letter from the DFS seeking information and data with regard to the foregoing. KICO provided information and data to the DFS and has cooperated with the DFS in connection with its investigation. KICO has not received a response from the DFS since a meeting held on May 23, 2013 and believes that such matter will not have any effect on our financial position or results of operations. In settling insurance claims, including those related to Superstorm Sandy, if KICO were to pay for losses not covered by the insurance policy, such as those based on water and sewer back up claims, it could face disclaimers of coverage from its reinsurers with regard to the amounts paid.
Recorded claim reserves for 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.
Difficult conditions in the economy could adversely affect our business and operating results.
Some economists project the potential for significant negative macroeconomic trends, including increased 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.
Our financial statements are subject to the application of generally accepted accounting principles, which are periodically revised, interpreted and/or expanded. Accordingly, we are required to adopt new guidance or interpretations, which may have a material adverse effect on our results of operations and financial condition that is either unexpected or has a greater impact than expected.
While we can take defensive measures, there can be no assurance that we will be successful in preventing attacks or detecting and stopping them once they have begun. Our business could be significantly damaged by a security breach, data loss or corruption, or cyber attack. In addition to the potentially high costs of investigating and stopping such an event and implementing necessary fixes, we could incur substantial liability if confidential customer or employee information is stolen. In addition, such an event could cause a significant disruption of our ability to conduct our insurance operations. We have a cyber insurance policy to protect against the monetary impact of some of these risks. However, the occurrence of a security breach, data loss or corruption, or cyber-attack, if sufficiently severe, could have a material adverse effect on our business results.
Our common stock is currently traded on The NASDAQ Capital Market. Our common stock is currently thinly traded and has substantially less liquidity than the average trading market for many other publicly traded insurance and other companies. An active trading market for our common stock may not develop or, if developed, may not be sustained. Thinly traded stocks can be more volatile than stock trading in an active public market. Therefore, shareholders have very little liquidity and may not be able to sell their shares at the volume, prices and times that they desire.
Subject to any required state insurance regulatory approvals, we are not restricted from issuing additional shares of our common stock in the future, including securities convertible into, or exchangeable or exercisable for, shares of our common stock. Our issuance of additional shares of common stock in the future will dilute the ownership interests of our then existing shareholders.
We have an effective registration on Form S-3 under the Securities Act registering for resale 659,100 shares of our common stock and effective registration statements on Form S-8 under the Securities Act registering an aggregate of 700,000 shares of our common stock issuable under our 2005 Equity Participation Plan and an aggregate of 700,000 shares of our common stock issuable under our 2014 Equity Participation Plan. Options to purchase 289,750 shares of our common stock are outstanding under the 2005 plan. Options to purchase 50,000 shares of our common stock are outstanding under the 2014 plan and 650,000 shares are reserved for issuance thereunder. The shares subject to the registration statement on Form S-3 will be freely tradeable in the public market. In addition, the shares issuable pursuant to the registration statements on Form S-8 will be freely tradable in the public market, except for shares held by affiliates.
As of March 15, 2016, our executive officers and directors beneficially owned 1,880,990 shares of our common stock (including options to purchase 157,500 shares of our common stock), representing 25.1% of the outstanding shares of our common stock.