Good day, ladies and gentlemen, and welcome to the Q1 2019 Kinsale Capital Group, Inc. earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. If anyone should require assistance during the conference, please press star then zero on your touch-tone telephone. As a reminder, this conference call may be recorded. Before we get started, let me remind everyone that through the course of the teleconference, Kinsale's management may make comments that reflect their intentions, beliefs, and expectations for the future. As always, these forward-looking statements are subject to certain risk factors which could cause actual results to differ materially. These risk factors are listed in the company's various SEC filings, including the 2018 annual report on Form 10-K, which should be reviewed carefully.
The company has furnished a Form 8-K with the Securities and Exchange Commission that contains the press release announcing its first quarter results. Kinsale's management may also reference certain non-GAAP financial measures in the call today. A reconciliation of GAAP to these measures can be found in the press release, which is available at the company's website at www.kinsalecapitalgroup.com. I will now turn the conference over to Kinsale's President and CEO, Mr. Michael Kehoe. Please go ahead, sir.
Thank you, operator. Good morning, everyone. Joining me today are Bryan Petrucelli, Kinsale's Chief Financial Officer, and Brian Haney, Chief Operating Officer. I'm going to start the call with a few introductory comments. Bryan Petrucelli will follow with our financial results. Brian Haney will follow him to discuss Kinsale's underwriting results and provide some market commentary. We'll conclude with Q&A. As a reminder, Kinsale combines disciplined underwriting and claim handling with technology-enabled low costs to deliver attractive returns and growth. We focus on smaller and sometimes hard-to-place accounts within the excess and surplus lines market. Unlike competitors, we maintain absolute control over the underwriting and the claim management process and do not outsource those functions to external parties. All of which help drive Kinsale's attractive loss ratios.
In addition, Kinsale uses proprietary technology and automation to operate at a significant expense advantage over many larger competitors. As we like to say, the combination of the disciplined underwriting and low costs is an end-game winner every time. For the first quarter, Kinsale posted strong profitability and growth. The combined ratio for the quarter was 80.3%. The annualized operating return on equity was 20%. These numbers are comfortably above our forward guidance of a mid-teens ROE and a mid-80s combined ratio. The growth we experienced in Q1 reflects the success of the Kinsale business strategy, in addition to the rising level of dislocation within the E&S market. For comparison purposes, the 32.5% Q1 growth was up from 27% in Q4 2018 and 23.5% for the calendar year 2018. Brian Haney's going to have some additional comments on the E&S market here in a moment.
first, over to Bryan Petrucelli for the financial report.
Thanks, Mike. As Mike mentioned, we had another strong quarter continued to generate market-leading combined ratios and returns for our investors. We reported net income of $18.7 million for the first quarter of 2019, an increase of 157% when compared to $7 million for the first quarter of 2018, due primarily to growth in the business, higher favorable development on prior accident year loss reserves, and increases in the fair value of our equity investments. Net operating earnings increased by 69% to $13.8 million, compared to $8.2 million for the first quarter of last year. Our effective income tax rate was 17.9% for the first quarter of 2019, relatively consistent when compared to 17.3% last year. The company generated underwriting income of $12.1 million on a combined ratio of 80.3%, compared to $6.9 million and 85.9% last year.
The combined ratio for the first quarter of 2019 included 10.4 points from net favorable prior year loss reserve development compared to 2.7% last year. CAT activity was negligible both this year and last year. Annualized operating return on equity was 20% for the first quarter of 2019 compared to 13.7% last year. As Mike noted, above our mid-teens or higher guidance. Gross written premiums were $84.6 million, representing a 32.5% increase over last year. Increases continued to be generated by an overall increase in underwriting activity across most lines of business, due to the reasons Mike already mentioned, including continued improvement in market conditions. Brian Haney will discuss that in a little more detail here in a bit.
On the investment side, net investment income increased by close to 40% over the first quarter of last year, up to $4.5 million from $3.2 million last year, as a result of continued growth in the investment portfolio and higher interest rates. Gross investment returns increased to 3.2% from 2.7% last year. Diluted operating EPS was $0.64 per share compared to $0.38 per share last year. With that, I'll pass it over to Brian Haney.
Thanks, Brian. As mentioned earlier, premium grew 32.5% in the first quarter. 16 out of our 17 divisions grew. We are seeing particularly strong growth in our Construction, Commercial Property, and Management Liability divisions, but the growth is widespread across many different divisions and classes of business. Our Aspera unit was up 39% for the quarter. Submission growth surged in the first quarter to 30%. We appear to be seeing substantial across-the-board increases in submission volume. We are not sure if the first quarter surge is a harbinger of things to come, but it is an excellent sign for us. At this point, the growth in submissions is such that it is now a bigger challenge for us to deal with the current flow of business than to find ways to accelerate that growth.
As a result, we are, from an operational perspective, prioritizing process improvements and incremental efficiency gains over product development or increasing distribution. That's not to say we are not researching new products or adding new brokers, just that we are giving those initiatives less priority relative to other projects that will help us address the flow of business opportunities while maintaining our superior customer service. As premium and submission growth have accelerated, we continue to be assertive in seeking more rate increases. We would prefer to grow through higher rate with greater margins than purely by increasing transaction count. While it can be problematic to reduce all the rate movements in a book as heterogeneous as ours to one number, if I had to do that, I'd say it was somewhere in the +5% to +7% range.
An important thing to keep in mind about our growth, we have not grown by changing our business model or by getting more aggressive on price, nor have we become more lax on underwriting standards. We are still executing essentially the same business plan we have been executing these past 10 years, including some recent years, like 2015 and 2016, where growth was much harder to come by. Our hit ratios, the proportion of quotes we issue that result in policies, haven't increased. In fact, they're lower this year than last. What seems to have changed is the market. We can't know how things will change from here. It's possible the market gets even more favorable, or it's possible it might reverse course. We don't know.
We will keep executing the same successful business model of low expenses, contrarian underwriting, and superior customer service that has gotten us to this point, and trust that whatever the condition of the market, we will continue to generate an attractive underwriting profit. With that, I'll turn it back over to Mike.
Thanks, Brian. Operator, we're now ready for Q&A.
Thank you. Ladies and gentlemen, if you have a question at this time, please press the star then the number one key on your touch-tone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. Again, that's star then one to ask a question. To prevent any background noise, we ask that you please place your line on mute once your question has been stated. Our first question comes from Mark Hughes of SunTrust. You may proceed with your question.
Yeah. Thank you very much. I think I might have missed it, did you mention the submission growth in the first quarter?
It's +30%.
Plus 30%?
Yeah.
How much of that, just thinking about the movement from the admitted market to the E&S market, could you talk about potential shifts that way, or is it just more underlying activity in the broader economy? How do you parse that, if you even can?
Mark, good morning. It's Mike Kehoe. Obviously, it's going to be a little bit speculative. We don't know definitively, but some of the early statistics on growth in E&S in 2018 indicate about an 11% growth for the market. Clearly, the E&S market overall is growing. Part of that's the economy, part of it is shift of business from standard to non-standard. Then the other element that's pretty positive for us is the fact that you've got a lot of companies dealing with maybe substandard results and retooling and re-underwriting books of business. So I think that's also a big positive.
Yeah, I think Lloyd's had come up in the prior conversations. Any comment on their apparent behavior in the market?
We don't have any comments about Lloyd's specifically, but just that if you read some of the trade press, clearly there's a lot of companies that are re-underwriting books of business. A lot of times the delegated underwriting programs or arrangements in particular can be subject to some volatility if the results haven't been adequate. Kinsale focuses on small commercial accounts for the most part. Our average premium is between $10,000 and $11,000 a policy. Candidly, I think we're one of the very few companies that underwrites that size of account with its own underwriters. Most of our competitors pursue that account size by delegating underwriting authority to either a program administrator or a wholesale broker. I think some of those delegated arrangements are being refined right now, and again, we're seeing the benefit of that.
A final question. On the expense ratio, if you sustain elevated top-line growth, would you expect the expense ratio to come down, or you think you're going to kind of peg it here at 24%-25%?
Mark, it's Bryan Petrucelli. I would think that we would expect it to stay pretty steady.
Thank you very much.
Thanks, Mark.
Thank you. Our next question comes from Jeff Schmitt of William Blair. You may proceed with your question.
Hi. Good morning, everyone. Could you provide some more detail on Aspera, how many states you're in there, and what the plans are and outlook is there?
Yeah. I would say, I don't have the exact number, but I think we're in something like 12 states. A lot of what we write is coastal manufactured housing, so it's personal insurance. The plan is to keep expanding that. We also write a small amount of commercial insurance in that, so we plan to keep expanding that. The growth rate has been slightly above the rest of the company for a while. I think it's an important means of diversifying the business. I think, the plan would be to keep growing that, and I would expect to see its growth rate exceed that of the rest of the company for the foreseeable future.
Okay. Just looking at the underlying loss ratio, ex-CAT development, it was up a decent amount, 240 basis points. Obviously, that can bounce around a lot. Is that being driven by kind of quarterly variability in business mix, or what's driving it?
Good morning, Jeff, it's Mike. I think, clearly part of it is just the inevitable variability from quarter to quarter, and then I think, probably some additional conservatism in the reserving there as well, would be the two reasons.
Okay, thank you.
Thank you.
Thank you. Our next question comes from Mark Dwelle of RBC Capital Markets. You may proceed with your question.
Yeah, good morning. About once every five years, I give out a great quarter, guys. This one looks like it's probably worthy of that, good job.
Thanks, Mark.
My first question. You mentioned, I guess 16 of the 17 business segments showed growth. Which one didn't, why do you think that was?
I think it was the Health Care Division. I think the Health Care Division writes non-standard doctors. I think that area has been challenged by Obamacare, which sort of created this impetus for smaller doctor offices, which is what we would've focused on, to join larger practices or to become associated with a hospital. When they do that, they kind of go out of our market. I think that's probably one of the reasons, although I'm speculating a little bit.
I think it's a boutique division for us within the company. It's pretty modest.
Okay, that's helpful. Any other areas that, where between a combination of pricing or otherwise that don't seem to be stacking up as well as the broader flow that you're seeing?
No. I think the general takeaway is that we're seeing a very broad, across-the-board opportunity, not just to grow the business, but to push rate and improve margins at the same time.
That's helpful. With respect to the surge in the submission flow, obviously, a kind of a high-class problem. Anything you just in kind of diagnosing that, any particular geographies, any particular types of wholesaler that you're seeing better flow from, or it's just the pipeline has gotten fatter?
Yeah. The remarkable thing about it is, as we look through the data, is just how diversified that phenomenon is. It seems to be in most places, with most brokers, most states. The other thing that was remarkable about it is kind of the abrupt shift. If you'll remember the last few quarters we were on these calls, the growth rate in submissions has been increasing, but it's always been a kind of very modest increase. It would go from 19 to 20 or 20 to 22. For it to go from 22-ish to 30 just that abruptly was-
Interesting
pretty interesting, yeah.
Okay. The last question, and I know I've asked this on prior calls, but just to kind of get an updated thought. With the growth rate that you're fortunate to be achieving, how much runway do you have before you would need to consider any type of capital actions or just something to make sure you keep your risk-based capital ratios and everything in the right place?
Right. Obviously, the stronger the growth, it starts to challenge our capital position, something we monitor very carefully. Depending on how the growth, with this kind of growth for the year, I think we would not need additional capital in 2019. If this kind of growth rate carried forward a year or two, almost certainly we will.
That's helpful.
That could be a combination of debt and equity.
Right. Okay. I think that's all my questions. Thank you.
Thanks, Mark.
Thank you. As a reminder, ladies and gentlemen, that's star then one to ask a question. Our next question comes from Adam Klauber of William Blair. You may proceed with your question.
Morning, guys.
Good morning.
Obviously good results. In the core liability, what's the rate of loss trend in general? Loss cost inflation?
I'll put it around 2% to 3%.
Okay. Great. I always ask this one. Are you continuing to see a bit more tougher litigation legal environment today than maybe two, three, four years ago?
We're a smaller company, so we don't have the same worldview that a large insurance conglomerate might have. Yes, in general, I think what we see is consistent with what's been reported here over the last year or so, where loss costs are trending upward and from time to time you see severity issues with jury verdicts and the like.
Great. As far as market conditions, obviously very strong growth in off good market coming off year-end. As I've talked to one or two contacts in the market, it's early, but they said June, July, the market could even be getting more firm in different areas than we saw at year-end. Are you getting some early sense of that?
No. Things are rolling along, I haven't heard anything that would lead me to believe that there's an upcoming further abrupt positive shift in the market.
Yeah. I think the general trend we've seen is over the last two years, there's been a steady improvement. Keep in mind, Adam, our book doesn't have a lot of seasonality to it because we don't write large accounts. Again, our average premium's a little bit over $10,000 a policy. I don't think June 1 or July 1 renewal dates are necessarily that impactful for us. I think that's our view.
Okay. Thanks a lot, guys.
Okay. Thanks, Adam.
Thank you. I'm not showing any further questions at this time. I would now like to turn the call back over to Michael Kehoe for any further remarks.
Okay. Thanks, operator. Thank you everyone for participating this morning, and we look forward to speaking with you again here in a few months.
Thank you. Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program, and you may all disconnect. Everyone, have a wonderful day.