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 2017 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 a press release announcing its third 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, and good morning, everyone. With me today are Bryan Petrucelli, Kinsale's Chief Financial Officer, and Brian Haney, Chief Operating Officer. After some introductory comments, I'll pass the call to Bryan Petrucelli, who will review Kinsale's financial highlights for the quarter, and then over to Brian Haney, who will provide some commentary on our quarter and discuss our market outlook. We usually like to begin these calls with a quick recap of the Kinsale strategy, which combines disciplined underwriting and claim handling with technology-enabled low costs to deliver attractive returns and growth to our stockholders, even in competitive markets like we have today. At Kinsale, we focus on smaller accounts within the E&S market, the Excess and Surplus lines market. We target hard-to-place accounts. We carefully manage the coverage we provide, in part to minimize inaccuracies in the underwriting process.
Unlike competitors, we maintain absolute control over the underwriting and the claim management process, and we do not outsource those functions to external parties. All of these strategies drive Kinsale's attractive loss ratios. In addition, because of our proprietary technology and automation, combined with a healthy owner-operator business culture, Kinsale operates with an enormous expense advantage over many larger competitors. The combination of disciplined underwriting and claim handling, combined with low costs, is an end-game winner every time. A couple of comments on the recent storm activity. As you recall, Kinsale writes catastrophe-exposed property. We think the margins in that business are compelling. We do so with a measure of conservatism in order to limit the volatility of the line, and specifically, I'm talking about a disciplined underwriting approach, strict limits on the concentration of business in any one geographic area.
We regularly model the book of business, and of course, we buy a fairly robust reinsurance program. As a consequence of this approach, Kinsale's recent catastrophe experience has been consistent with both our risk appetite and our expectations. Our current estimates for the Florence losses are about $300,000, and Hurricane Michael current loss estimates are about $4 million pre-tax. With that, I'm going to pass the call over to Bryan P. Petrucelli.
Thanks, Mike. The results for the third quarter were in line with our expectations. We believe the 84.6% combined ratio for the quarter is a market leader and continues to demonstrate the strength of our low-cost model, particularly in periods of intense price competition. We reported net income of $11.9 million for the third quarter of 2018, a 184% increase over the $4.2 million reported in the third quarter of 2017. Net operating earnings increased by 153% to $10.6 million, compared to $4.2 million last year. Increases in net income and operating earnings were largely driven by the cat losses in 2017, an increase in net investment income, and a reduction in the company's effective income tax rate. Our effective income tax rate was 17.1% for the first nine months of 2018, compared to 30.5% last year, and lower primarily due to the impact of the Tax Reform Act.
The company generated underwriting income of $8.4 million and a combined ratio of 84.6%, compared to $2.5 million and 94.5% last year. The combined ratio for the third quarter of 2018 included four points from net favorable prior year loss reserve development compared to 6.4 points last year. There was no meaningful cat activity for the quarter. However, cat losses contributed 17.9 points to the combined ratio in the third quarter of 2017. Annualized operating return on equity increased to 15.4% for the first nine months of 2018, and in line with our mid-teens guidance, compared to 11.4% last year. Gross written premiums were $69.5 million, representing a 25% increase over the third quarter of 2017. They continue to be generated from an overall increase in underwriting activity across most lines of business. Brian D. Haney will get into a little more detail on that here in a bit.
On the investment side, net investment income increased by 47.7% over the third quarter of last year to $4.1 million from $2.8 million as a result of the continued growth in investment portfolio and rising interest rates. Annualized gross investment returns increased to 2.9% from 2.4% last year. Basic and diluted EPS were $0.55 and $0.49 per share, respectively, for the quarter, compared to $0.20 per share for both last year. With that, I'll pass it over to Brian D. Haney.
Thanks, Brian. As mentioned earlier, premium grew 25% in the third quarter, which is higher than the rate for the first two quarters of the year. All but one of our 17 divisions grew. The Allied Health, Commercial Property, and Management Liability divisions all grew robustly. Our Aspera business was up 39% for the quarter. Overall, submissions continue to increase at a strong pace. Submissions in the third quarter were up 24% over the third quarter of 2017. The vast majority of our 17 divisions had positive growth in submissions. We look at this as a good leading indicator for where the business is going. Given that growth has been easier to come by, we have looked to push rates up where appropriate. We have a very heterogeneous mix of business, so it's difficult to boil all the various rate movements down to a single number.
If we had to do that, we'd say the number was somewhere in the 2%-4% range. The market continues to be in a transitional state. Some areas like Allied Health and Commercial Auto are definitely experiencing some firming, other areas not so much. As we've noted in the past few years, there is some stress in the program space which tends to inure to our benefit. While we ourselves aren't in the program space and we don't give out underwriting authority to third parties, we do tend to see more opportunities when competitors' programs are experiencing poor results and having to shed business or shut down. I suspect the industry will continue to see more poor results coming out of some programs in the next few years. We continue to feel good about the state of the market and about our competitive position.
Submission growth is good and accelerating. We are taking rate where appropriate, and we expect to continue to do that and perhaps press even more in that regard. Results are good. We continue to make incremental improvements in our internal processes to get out more quotes and get them out faster, which should allow us to capitalize better on the opportunities that come our way. With that, I'll turn it back over to Mike.
Thanks, Brian. Operator, we're now ready for any questions in the queue.
Will do. Ladies and gentlemen, if you have a question at this time, please press star, then the number one key on your telephone keypad. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. Once again, that's star one for questions, star one. Our first question comes to the line of Mark Hughes from SunTrust. You may begin.
Yeah, thank you very much. Good morning.
Good morning, Mark.
The 24% growth in submissions, any way to break that out in terms of the kind of the buckets it's coming from, new relationships with wholesalers.
just deeper penetration, you name it.
I would say it's very widespread. It's tough to break it out into one class or segment. Some of it is certainly coming from new producers. Most of it is just coming from just getting more traction with the producers and products we already have.
It could be-
Could the ex-.
I was just going to say, the E&S market, I think, is growing at a pretty good clip now as well, so that's probably part of it as well.
The expense ratio in the quarter was still quite good, but at the higher end of the recent range. Is anything unusual this quarter? I think you've been at 24% area, low twenty-fours. How would you see that going forward? Is this a good level, or should it go back to the lower end of the range?
I would say, Mark, there's always some natural variability from quarter to quarter in expenses. I think that 25%-25.5% or 26% loss ratio is probably in line with our expectations. I think what you're seeing in some of those quarters that were a little lower, particularly the third quarter of 2017, if you remember, we did have some cat activity. Those losses would have sort of a negative impact on the variable comp that we book for the quarter. I think that's what you're seeing there.
The pre-tax impact from Michael as opposed to Florence, $4 million on Michael. Could you talk about what exposure you had there that made that more meaningful?
It's all personal insurance business. Our personal insurance targets manufactured homes in the, from, it's basically the southeastern coastal communities. It was exclusively a personal insurance event for us.
Thank you.
The size of the loss was consistent with our business plan and our risk appetite.
Thank you.
Okay. Thanks, Mark.
Our next question comes from the line of Jeff Schmitt from William Blair. You may begin.
Good morning, everyone.
Good morning, Jeff.
Aspera obviously growing at a high rate here, has been growing at a pretty high rate for some time. How big is that book now? How many states are you in there now?
The book is growing at a good clip, in part because we're expanding geographically.
A couple of years ago, I think we were in two states, Florida and South Carolina. Now we have business from Texas up to the Mid-Atlantic, and we expect the geographic footprint to continue to grow. I don't have, off the top of my head, the number of states, but you can think about a dozen or so.
Mm-hmm. Okay.
Yeah.
And-
We'll probably write, I think, somewhere in the low to mid-teens this year in terms of premium volume.
Okay. Just looking at the underlying loss ratio, up close to 400 basis points, similar to last quarter. Can you maybe discuss what's driving that? How much is big business mix shift versus are you seeing any changes in underlying trends?
Yeah. I think you're referring to our current accident year loss ratio when you exclude the changes from prior periods.
Right
To slightly higher. I think in general, we feel very good about the profitability of the business. There's no pernicious trends that we're concerned about. Of course, there is steady loss cost inflation that we always take into account in our pricing. I would say in general, we try to be very conservative in how we reserve. The goal is to set the reserves high enough that they're very likely to develop favorably over the years ahead. In general, I would attribute it to we're executing that strategy, always looking to put up conservative numbers.
In general, I think we feel very good about the book.
Okay. Just one quick one on the tax rate, 15% for the quarter, 17% year-to-date. I think you had guided to more like 19. Is there a change in guidance at all there, or?
I wouldn't say a change in guidance. I think one thing that's difficult to predict, and whenever there's any stock options that are exercised, you do get a tax benefit, and that's going to vary from quarter-to-quarter. I think the 19% is a good guide. If there is heightened level of stock option exercises, obviously it's going to be a little lower.
Right. Okay. Thank you.
Thanks, Jeff.
Our next question comes to the line of Mark Dwelle from RBC Capital Markets. You may begin.
Good morning. A couple of mine have already been covered, but just a quick numbers kind of question on the net to gross premium retention, a little bit lower this quarter than some. Is that just timing or mix, or is there some more fundamental change?
Mark, good morning. It's Mike Kehoe. That's just purely mix of business. We cede off a high percentage of the premium on our excess casualty business where we put up larger limits. We cede off kind of a medium level if you look at some of our property lines where we have a risk cover and a cat cover, then on our primary casualty, we keep that business net. As the mix shifts a little bit, you're going to see a little bit of movement quarter to quarter, but there's no change in strategy.
Okay. That makes sense. You commented a couple of times in the course of various remarks just about the E&S market growing. Would you view that growth as a migration of risk from the standard markets to the E&S? Or is this just primarily the function of a kind of a strong economy and lots of new business and construction and whatnot?
I think it's both, right? In a period of strong economic growth, a lot of business formations, new businesses typically start in the non-standard market, and then they can migrate away down the road. I think there's a long-term trend where the non-standard or the excess in surplus lines market is taking market share, if you will, from the standard market. I'm thinking of the AM Best report that came out about a month ago where they looked back, I think, over a 20-year period, and the E&S market went from about 7% of the commercial P&C market 20 years ago to about 14% or 14.5% today. It's a long, steady growth of one market at the expense of the other, although not every year. It does ebb and flow.
Guess that's why it's good to be an E&S writer. I'll stop there. Those are all my questions.
Thanks. Thanks, Mark.
Thanks.
Our next question comes from the line of Mark Hughes from Truist. You may begin.
Yeah, thank you. You talked about the hardening pricing perhaps in the Allied Health and Commercial Auto. Just curious for an update of how close the pricing might be in the Commercial Auto category. When could it possibly get a little more interesting for you?
Tough question to answer. It's definitely getting there, and we are definitely looking at
New products all the time, and some of those products are related to Commercial Auto, but we're not there yet.
Roughly speaking, how far away are you? 50%? 20%?
That's tough to answer. I would say it's probably not 50%.
Yeah. Commercial Auto rates have moved up dramatically over the last couple of years in reaction to just an abysmal amount of losses for the industry. Typically, when a market's in shambles, hey, there's opportunity. I think we're a lot closer than we were three years ago. Again, we don't have a specific number to throw out today. It is something we monitor all the time.
Then could you mention again, you said 16 out of 17 divisions grew, and I think you very quickly touched on a few of those. Where were you seeing more growth in your different areas?
Allied Health's growing pretty well. Commercial Property, Management Liability is growing pretty well. It is pretty widespread. We've got a lot of divisions that are up pretty significantly. Our excess casualty book's growing pretty well. Obviously, Aspera is growing pretty well.
Great. Thank you.
Thanks, Mark.
Thank you. I'm showing no further questions at this time. I'd like to turn the call back to the speakers for closing remarks.
Okay. Well, I just want to thank everybody for joining us on the call today, and we look forward to talking to you again down the road in a few months.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone, have a great day.