The current yearly aggregate base rental for our executive offices is approximately $39,000. We own the building from which our insurance underwriting business operates, free of mortgage.
Effective July 1, 2009, we commenced offering property and casualty insurance products to small businesses and individuals in New York State through our subsidiary, KICO. The effect of the KICO acquisition is only included in our results of operations and cash flows for the period from July 1, 2009 (the KICO acquisition date) through December 31, 2010. Accordingly, discussions for the year ended December 31, 2010 will pertain for the entire period. For the year ended December 31, 2009, discussions pertaining to KICO will only include the six months ended December 31, 2009.
Acquisition transaction costs. Acquisition transaction costs are the costs we incurred directly related to the acquisition of KICO. Theses costs consist of fees for legal, accounting and appraisal services.
Interest income - CMIC note receivable. We accrued interest income and accreted the discount on the surplus notes of CMIC before the acquisition of KICO on July 1, 2009.
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 and other underwriting expenses less ceding commission revenue less other income to net premiums earned.
Net premiums earned less expenses (expenses are net of ceding commissions and other income) included in combined ratio (underwriting income). Underwriting income is a measure of an insurance company’s overall operating profitability before items such as investment income, interest expense and income taxes.
Our consolidated financial statements include the accounts of Kingstone Companies, Inc. and all majority-owned and controlled subsidiaries. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires our management to make estimates and assumptions in certain circumstances that affect amounts reported in our consolidated financial statements and related notes. In preparing these financial statements, our management has utilized information available including our past history, industry standards and the current economic environment, among other factors, in forming its estimates and judgments of certain amounts included in the consolidated financial statements, giving due consideration to materiality. It is possible that the ultimate outcome as anticipated by our management in formulating its estimates inherent in these financial statements might not materialize. However, application of the critical accounting policies below involves the exercise of judgment and use of assumptions as to future uncertainties and, as a result, actual results could differ from these estimates. In addition, other companies may utilize different estimates, which may impact comparability of our results of operations to those of companies in similar businesses.
We have changed the presentation of our business results prior to July 1, 2009 by reclassifying our previously reported continuing operations based on reporting standards for insurance underwriters. The prior period disclosures have been restated to conform to the current presentation. General corporate overhead not incurred by our underwriting business is allocated to other operating expenses.
The following table summarizes the changes in the results of our operations (in thousands) for the periods indicated (unaudited):
(A) Year ended December 31, 2009 includes only the period from July 1, 2009 (the KICO acquisition date) through December 31, 2009.
(B) Not applicable due to the acquisition of KICO on July 1, 2009, see separate discussion of the results of KICO for the six months ended December 31, 2010 compared to six months ended December 31, 2009.
The positive cash flow and increase in invested assets from operations was the result of the KICO acquisition. The tax equivalent investment yield, excluding cash, was 5.74% and 4.94% at December 31, 2010 and 2009, respectively. Realized capital gains (losses) from securities acquired in the KICO acquisition had a cost basis equal to their fair market value as of the acquisition date on July 1, 2009.
Total expenses in 2010 were $19,747,000, as compared to $8,610,000 in 2009. The increase in total expenses in both periods was due to the increases in all categories of expenses stemming from the acquisition of KICO that occurred on July 1, 2009, offset by a decrease in acquisition costs and interest expense on mandatorily redeemable preferred stock. Acquisition costs were eliminated in 2010 as they were related to the acquisition of KICO in 2009. The reduction in interest expense on mandatorily redeemable preferred stock was due to the exchange of all of the outstanding preferred stock into common stock on June 30, 2010, which resulted in the elimination of additional related interest expense as of that date. Other operating expenses not related to KICO were $1,262,000 in 2010 compared to $1,093,000 in 2009. The $169,000 increase in 2010 was primarily due to our Chief Executive Officer’s bonus compensation and increase in his base compensation, which are pursuant to his amended employment agreement dated March 24, 2010. The $259,000 increase in non-cash compensation from $89,000 in 2009 to $348,000 in 2010 is due to stock and option grants to our Chief Executive Officer pursuant to his amended employment agreement dated March 24, 2010.
Gain on acquisition of Kingstone Insurance Company of $5,178,000 in 2009 is attributable to the bargain purchase which was a result of the excess of net assets acquired from KICO compared to the acquisition cost.
Interest income from CMIC notes receivable in 2010 was $-0-, as compared to $61,000 in 2009. The decrease in 2010 was due to the forgiveness of the notes receivable in exchange for our 100% equity interest of KICO on July 1, 2009.
The provision for income taxes (including state taxes) was $767,000 in 2010, as compared to a tax benefit of $67,000 in 2009. The increase in 2010 was due to the inclusion of KICO earnings for the full year in 2010 compared to only six months in 2009. The gain on acquisition of KICO in 2009 is being treated as a permanent difference for income tax purposes. The tax provision/benefit on income from continuing operations in both periods include the current tax provision/benefit resulting from discontinued operations.
The following table summarizes the changes in the results of our discontinued operations (in thousands) for the periods indicated:
The provision for income taxes in 2010 and 2009 are due to deferred tax adjustments related to the disposition of the businesses and entities that were sold in 2009.
Net income was $983,000 for 2010, compared to $4,821,000 in 2009. The decrease in net income of $3,837,000 was due to the $5,178,000 gain on acquisition of KICO in 2009, offset by the inclusion of KICO earnings for the entire period during 2010 compared to only six months in 2009 and the cessation of our discontinued operations in 2009.
Due to the acquisition of KICO and the commencement of our insurance underwriting business on July 1, 2009, the comparability of information between years is less meaningful. The results of operations for the years ended December 31, 2010 and 2009 include KICO for the entire year in 2010 and only for six months in 2009; as a result we have decided to include the following discussion comparing KICO’s results of operations for six month period ended December 31, 2010 to the six month period ended December 31, 2009.
Commission expense was $2,697,000 in 2010 or 16.2% of gross premiums written. Commission expense was $2,233,000 in 2009 or 16.5% of gross premiums written. The increase of $464,000 or 20.8% is due to the 22.7% increase in gross premiums written in 2010 as compared to 2009.
Income tax expense in 2010 was $450,000, which resulted in an effective tax rate of 32.8%. Income tax expense in 2009 was $293,000, which resulted in an effective tax rate of 36.2%. The decrease in our effective rate resulted, primarily, from an increase in tax exempt interest.
The key measures for our insurance underwriting business for the year ended December 31, 2010 are as follows:
As more fully described in Note 4 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, 2010, and concluded that the unrealized losses in these asset classes are the result of a decrease in value due to technical spread widening and broader market sentiment, rather than fundamental collateral deterioration, and are temporary in nature.
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, 2010 and 2009:
There are 60 securities at December 31, 2010 that account for the gross unrealized loss, none of which is deemed by us to be other than temporarily impaired. There are 26 securities at December 31, 2009 that account for the gross unrealized loss, none of which is deemed by us to be other than temporarily impaired. Significant factors influencing our determination that unrealized losses were temporary included the magnitude of the unrealized losses in relation to each security’s cost, the nature of the investment and management’s intent not to sell these securities and it being not more likely than not that we will be required to sell these investments before anticipated recovery of fair value to our cost basis.
Effective July 1, 2009, the primary sources of cash flow is from our insurance underwriting subsidiary, KICO, which are gross premiums written, ceding commissions from our quota share reinsurers, loss payments by our reinsurers, investment income and proceeds from the sale or maturity of investments. Funds are used by KICO for ceded premium payments to reinsurers, which are paid on a net basis after subtracting losses paid on reinsured claims and reinsurance commissions. KICO also uses funds for loss payments and loss adjustment expenses on our net business, commissions to producers, salaries and other underwriting expenses as well as to purchase investments and fixed assets.
In connection with the plan of conversion of CMIC, we have agreed with the Insurance Department that for a period of two years following the effective date of conversion of July 1, 2009, no dividend may be paid by KICO to us without the approval of the Insurance Department. As of December 31, 2010, no such request has been made by us to the Insurance Department. We have also agreed with the Insurance Department that certain intercompany transactions between KICO and us must be filed with the Insurance Department 30 days prior to implementation and not disapproved by the Insurance Department.
The increase in cash flows provided by operating activities in 2010 was primarily a result of the additional operating cash flows provided through the acquisition of KICO on July 1, 2009 and the cessation of our discontinued operations in 2009.
Net cash flows used in investing activities increased as a result of the investing cash flows used through the acquisition of KICO on July 1, 2009 and the decrease in proceeds from the sale of businesses in 2010 as compared to 2009.
In accordance with GAAP guidance for accounting for certain financial instruments with characteristics of both liabilities and equity, our mandatorily redeemable preferred stock has been reported as a liability of $1,299,231 on December 31, 2009. Effective June 30, 2010, we issued 787,409 shares of Common Stock in exchange for 1,299 shares of our outstanding mandatorily redeemable Series E Preferred Stock. The value of the exchanged Series E Preferred Stock was approximately $1,299,231. The effective price for the exchange was $1.65 per share of Common Stock, which was approximately equal to the fair value of the common stock issued. For the year ended December 31, 2010 and 2009, the preferred dividends of $74,706 and $127,158, respectively have been classified as interest expense.
The following table summarizes each reinsurer that accounted for approximately over 10% of our reinsurance recoverables on paid and unpaid losses and loss adjustment expenses as of December 31, 2010:
Personal Lines business, which includes homeowners, dwelling fire and canine legal liability, is reinsured under a 75% quota share treaty which provides coverage up to $700,000 per occurrence. An excess of loss contract provides $1,500,000 in coverage excess of the $700,000 for a total coverage of $2,200,000 per occurrence. Personal umbrella business written is reinsured under a 90% quota share treaty limiting the Company to a maximum of $100,000 per occurrence for the first $1,000,000 of coverage. The second $1,000,000 of coverage is 100% reinsured.
We obtained $41,000,000 of catastrophe coverage , where we retain $500,000 per occurrence. To determine the amount of catastrophe insurance required, we used accepted industry models that predict the probable maximum loss that we could incur in a 125 year storm.
Our reinsurance program is structured to enable us to reflect significant reductions in premiums written and earned and also provides income as a result of ceding commissions earned pursuant to the quota share reinsurance contracts. This structure has enabled us to significantly grow its premium volume while maintaining regulatory capital and other financial ratios generally within or below the expected ranges used for regulatory oversight purposes. Our participation in reinsurance arrangements does not relieve us from our obligations to policyholders.
We are a holding company and a legal entity separate and distinct from our operating subsidiary, KICO. As a holding company without operations of our own, the principal sources of our funds are dividends and other payments from KICO. Consequently, we must rely on KICO for our ability to repay debts, pay expenses and pay cash dividends to our shareholders. In connection with the plan of conversion of Commercial Mutual Insurance Company (“CMIC”) into KICO, we have agreed with the New York State Insurance Department that, until July 1, 2011, without the approval of the Insurance Department, no dividend may be paid by KICO to us.
In addition, we are subject to claims arising from weather events such as winter storms, rain, hail and high winds. The incidence and severity of weather conditions are largely unpredictable. There is generally an increase in the frequency and severity of claims when severe weather conditions occur.
Financial strength ratings are important factors in establishing the competitive position of insurance companies and generally have an effect on an insurance company's business. Many insurance buyers, agents and brokers use the ratings assigned by A.M. Best and other agencies to assist them in assessing the financial strength and overall quality of the companies from which they are considering purchasing insurance. In 2009, KICO applied for its initial A.M. Best rating, and was assigned a letter rating of “B” (Fair) by A.M. Best in 2010. KICO is in the process of undergoing its annual review by A.M. Best, which may result in a change to its rating. A. M. Best ratings are derived from an in-depth evaluation of an insurance company’s balance sheet strengths, operating performances and business profiles. A.M. Best evaluates, among other factors, the company’s capitalization, underwriting leverage, financial leverage, asset leverage, capital structure, quality and appropriateness of reinsurance, adequacy of reserves, quality and diversification of assets, liquidity, profitability, spread of risk, revenue composition, market position, management, market risk and event risk. On an ongoing basis, rating agencies such as A.M. Best review the financial performance and condition of insurers and can downgrade or change the outlook on an insurer's ratings due to, for example, a change in an insurer's statutory capital, a reduced confidence in management or a host of other considerations that may or may not be under the insurer's control. We currently have a Demotech rating of A (Excellent), which qualifies our policies for banks and finance companies. All ratings are subject to continuous review; therefore, the retention of these ratings cannot be assured. A downgrade in any of these ratings could have a material adverse effect on our competitiveness, the marketability of our product offerings and our ability to grow in the marketplace.
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.
If we lose key personnel or are unable to recruit qualified personnel, our ability to implement our business strategies could be delayed or hindered; KICO’s Chief Executive Officer will be transitioning his duties and responsibilities effective January 1, 2012.
Legislation concerning tort reform is from time to time considered in the United States Congress. Among the provisions considered for inclusion in such legislation are limitations on damage awards, including punitive damages. Enactment of these or similar provisions by Congress or by the state of New York could result in a reduction in the demand for liability insurance policies or a decrease in the limits of such policies, thereby reducing our revenues. We cannot predict whether any such legislation will be enacted or, if enacted, the form such legislation will take, nor can we predict the effect, if any, such legislation would have on our business or results of operations.
The financial statements required by this Item 7 are included in this Annual Report following Item 15 hereof. As a smaller reporting company, we are not required to provide supplementary financial information.