Before we get started, let me remind everyone that through the course of the teleconference, Kinsale 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 the press release announcing its second 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 also available at the company's website at www.kinsalecapitalgroup.com. I would now like to turn the conference over to Kinsale's President and CEO, Mr. Michael Kehoe.
Please go ahead, sir.
Thank you, operator, and good morning, everyone. Joining me on today's call is Bryan Petrucelli, Chief Financial Officer for Kinsale, and Brian Haney, Chief Operating Officer. I'm going to make a few introductory remarks and then turn the call over to Bryan Petrucelli for some detailed financial information, and then Brian Haney will follow with some color on our quarter and the market opportunity that we see in front of us. Kinsale is a specialty insurance company that combines disciplined underwriting and claim handling with an advanced level of technology and low costs to deliver superior value to our customers and superior returns to our stockholders. At Kinsale, disciplined underwriting begins by our maintaining absolute control over the underwriting and claims management process, unlike most insurance companies that contract out some or all of their underwriting to external parties.
It involves targeting small to medium-sized, hard-to-place accounts within the excess and surplus lines market to achieve superior risk-adjusted returns. It means managing the coverage we offer to minimize inaccuracies in the underwriting process. All of these elements help drive Kinsale's favorable loss ratios. On the expense side, Kinsale uses its own proprietary end-to-end enterprise system, designed and built by our analysts and developers to operate our company. Most competitors are at the disadvantage of using multiple systems, sometimes dozens of systems, to operate their businesses. Using a single advanced enterprise system that we own allows Kinsale to achieve a significant cost advantage in addition to providing superior customer service, more accuracy, and more data to manage the business than our competitors.
The end result of this technology, combined with Kinsale's entrepreneurial business culture, is an expense ratio dramatically lower than our competitors, 20% lower or 25% lower, in some cases even 35% lower. It's a powerful advantage in an industry where the buyer cares so much about the cost of the policy. Combining disciplined underwriting and claim handling with low costs is an endgame winner every time. For the second quarter, net operating earnings increased by almost 17%. Premiums increased by 21%. Our combined ratio was 83.5%, and our operating return on equity for the six months of 2018 was 14.9%. The quarter and six-month results are consistent with our forward guidance of a mid-80s combined ratio and a mid-teens ROE. For further detail, I'll turn the call over to Bryan Petrucelli.
Thanks, Mike. As Mike noted, the results for the second quarter were in line with our expectations. Although slightly higher than last year, we believe the 83.5% 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 $10.1 million for the second quarter of 2018, an increase of 19% over the $8.5 million reported last year. Net operating earnings increased by 16.8%, $9.9 million compared to $8.5 million last year. Increases in net income and operating earnings were largely driven by an increase in net investment income and a reduction in the company's effective income tax rate.
Our effective income tax rate was 18.2% in the second quarter, compared to 33% last year, and lower due to the impact of the Tax Reform Act that was enacted at the end of 2017 and the recognition of tax benefits from stock options that were exercised during this quarter. The company generated underwriting income of $8.4 million and a combined ratio of 83.5%, compared to $10.7 million and 75.2% for the second quarter of 2017. The combined ratio for the second quarter of 2018 included 3.6 points from net favorable prior year loss reserve development, compared to 8.9 points from net favorable loss reserve development last year. There was no meaningful cat activity this quarter or the second quarter of last year. Annualized operating return on equity increased to 14.9% for the first half of 2018, compared to 13.5% last year.
Gross written premiums were $69.9 million, representing a 21% increase over the second quarter of 2017.
Continue to be generated from an overall increase in underwriting activity across most lines of business. Brian Haney will discuss that in a little more detail here in a bit. On the investment side, net investment income increased by 55.5% over the second quarter of 2018, up to $3.8 million from $2.4 million last year. Annualized gross investment returns increased to 2.9% from 2.3% last year. Basic and diluted operating EPS was $0.47 and $0.46 per share respectively, compared to $0.40 per share last year. With that, I'll pass it over to Brian Haney.
Thanks, Brian. As mentioned earlier, premium grew 21% in the second quarter, roughly the same from the first quarter. All but two of our 17 divisions grew. Commercial property continues to grow strongly, and our Allied Health division was up 40% for the quarter. We are seeing more opportunities in the Allied Health space because a number of our competitors have re-underwritten their books of business. On the other hand, we shrank slightly in our construction division due to a strategic push on our part for more rate. Our general casualty division, which operates in a particularly competitive part of the E&S space, was also down slightly. Our specialty insurance was up 42% for the quarter. Overall, submissions continue to increase strongly. Submissions in the fourth quarter were up 22% over the fourth quarter of 2017.
We look at submissions as a good leading indicator for where the business is going, the vast majority of our 17 divisions had positive growth in submissions. It's worth reminding you there are two things in particular about how we underwrite business that separate us from most of our competitors. First, we are 100% E&S. We don't write any admitted business. This gives us great flexibility by giving us the freedom to tailor rates and forms to the specific, unique risks faced by our insureds. Second, we don't delegate underwriting authority to third parties. This, we believe, gives us greater control over the underwriting and risk selection and drives a more profitable result. Moving on to rates, we continue to push rates up selectively. We took some rate increases in our casualty business in the second quarter, which contributed in part to the construction division's modest shrinkage.
The overall rate change for the book is still in the low single digits. One positive indicator with regards to market conditions is that we are seeing a handful of opportunities on large accounts, we are converting on some of those opportunities. This is significant because large accounts, and by large, I'm thinking accounts over $100,000 in premium, tend to draw irrational levels of competition. Normally it's difficult for us to compete, given that we aren't willing to lose money just to get premium. When we see more success on large accounts, as we did this past quarter, that is to us an indication that the market is behaving more rationally, which is a good sign. That being said, the mainstay of what we write is still small to medium accounts.
While we can't be 100% sure what is causing the increase in opportunity we are seeing, we are seeing it. The submissions continue to increase at a very healthy rate. Looking back now, it seems that the market has been trending in a favorable direction for us since 2016. Each quarter for the last four is at a higher growth rate than the previous quarter, and we're finding growth easier to come by than we were prior to 2017. We feel cautiously optimistic about where this is heading. With that, I'll turn it back over to Mike.
Thanks, Brian. Operator, we're ready for any questions that come in.
Thank you. Ladies and gentlemen, if you have a question at this time, please press star then one 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. To prevent any background noise, we ask that you please place your line on mute once your question has been stated. Again, that is star then one if you would like to ask a question. Our first question comes from the line of Mark Hughes with SunTrust. Your line is now open.
Thank you. Good morning.
Good morning, Mark.
The 22% increase in submission count, what period was that for again?
That was the second quarter over second quarter.
Second quarter over second quarter. Okay.
Yeah.
I think you suggested that continues to be robust here in the third quarter?
I don't know if we're supposed to mention that. I would expect it to continue at the rate it's going.
Okay. Thinking about the favorable development, last few quarters have been more like flat up kind of low single digits, a little bit behind your earlier pace in early 2017, full year 2016. How do you see losses developing in the book? Do you notice any kind of change in the trajectory there or any inflation, perhaps a little bit more? What's going on?
I think whenever you compare different quarters or different years, you have to acknowledge there's some variability in our results just based on the natural volatility in the business and the fact that, hey, as a smaller company, that probably exacerbates the volatility a little bit. I think if you're comparing second quarter 2018 with 2017, second quarter in 2017 was a bit of an anomaly. It was kind of an exceptionally good quarter. We think second quarter 2018 was exceptionally good as well, but not quite as good. In terms of loss trends, I think there's definitely inflation in jury verdicts and damages and that type of thing. It's something we address in our actuarial review and our profitability analysis in all of our divisions. It's just a normal part of how we manage our pricing to account for inflation on the claims front.
I don't know that there's anything exceptional underway today.
You would say the inflation is similar to what you've seen in prior years? Has it picked up a little bit?
I would say it's similar to what we've seen.
The large accounts, you had mentioned you're seeing some opportunities that are emerging there. Anything you can spot in terms of end markets or types of business or line that are creating that opportunity?
It's across the board. I would say there's some more in the Allied Health space in the skilled nursing facilities, but many of our divisions are seeing these accounts.
I would also emphasize that we're talking about a handful of accounts, right? Our strategy has been to focus on the small to medium-sized transactions because, hey, we think in a competitive market, that's where the best margins are, and that's consistent today. I think Brian mentioned that on his remarks more as a indication of a market trend that's becoming a little bit more favorable to the risk bearer. The fact that we used to see no opportunity for larger accounts, now we might see five or 10 a month.
Just final follow-up. On those larger accounts, would you normally put up a higher loss pick associated with that? You're getting more volume, the profit contribution is good, it might involve a little higher loss ratio.
We're not going to reserve specifically for a handful of accounts. We don't specifically address it in the reserving. I will say this, though, these accounts that come to us are distressed. They've had really bad loss experience, they get a very high rate when they come to us. I would expect these accounts, the handful that we do right, I would expect them to actually have better loss experience.
Understood. Thank you.
Thanks, Mark.
Thank you. Our next question comes from the line of Mark Dwelle with RBC Capital Markets. Your line is now open.
Yeah, good morning. Mark Hughes took a few of my questions already. I want you to say on the results, I think I appreciate the market commentary that you've given. As you look at the areas where you're growing or where you're contracting, I guess, what portion of the growth would you say is primarily driven just by being a strong economy, which usually drives a lot more E&S volumes as compared to how much is because you continue to penetrate the market and expand your distribution relationships and so forth?
Good morning, Mark. This is Mike Kehoe. I don't know that we actually have a precise answer to that. Clearly, part of our growth is driven by, we got a very robust economy, and that's probably driving growth across the P&C industry. I think clearly the E&S segment is growing at the expense of the standard market, which is a long-term trend, not every year, but most years E&S has been taking share, if you will, from the standard lines segment. I think clearly, with Kinsale's strategy and business model, we are taking market share from our competitors. Brian, I don't know if you have any.
I think one way you could sort of guesstimate that number is just to look at the growth in the E&S market as a whole and say that the difference between our growth rate and that average growth rate is probably our taking market share.
Okay.
Which I would guess would be somewhere around half and half.
In the Allied Health line that you talked about, I assume that's primarily a liability exposure. Can you just describe a little bit more about kind of what exposures you're writing there, just by way of kind of understanding the risks?
Yeah. The Allied Health division at Kinsale focuses on essentially non-physician, non-hospital healthcare risks. It's everything from home healthcare agencies, social service, drug and alcohol treatment, independent living, assisted living, skilled nursing homes. The one thing we've noticed here in the last year or two is that the market for this liability insurance for skilled nursing homes, the pricing has firmed up. Up until about a year or so ago, we wrote no business in that segment because the rates had come down so low that it was not a favorable risk trade for us as the risk bearer. Now that you've seen the low prices beget losses in some companies, we've seen carriers withdraw from the market. There's a lot more dislocation in that segment. Still very competitive.
It's not an area where we're writing a ton of business, but we're starting to see some opportunities, and that's it. The big driver of losses in a liability book for skilled nursing homes would be resident injury, either improper medical care, could be a fall, that type of thing.
Okay, that's helpful. Thank you. Last question I had, just in terms of the investment portfolio. Obviously, it continues to benefit. Any changes or anything different that's happening there that is worth noting?
Mark, it's Bryan at Petrucelli. Not really. No real changes in the strategy other than what we've talked about in the past. Still continuing to purchase some floating rates and CLOs, just to take advantage of some of the increases in interest rates that we've seen. No dramatic changes there.
Basically, the size of the portfolio, of course, continues to grow at a healthy clip.
Of course, that's the good part. That's all my questions. Thanks very much.
Thanks, Mark.
Thank you. As a reminder, if you would like to ask a question, please press star then one on your touchtone telephone. Our next question comes from the line of Adam Klauber with William Blair. Your line is now open.
Morning, guys.
Good morning, Adam.
How fast did Aspera grow, and how big is that unit now?
I think, didn't you say 42% growth for the quarter? It'll come in somewhere around 5% of our book this year, up from, I think, 4.25% of our books last year.
Okay.
It's a small part of the business, but it's growing at a healthy clip.
Yep. Did you grow your property book? How did the property book grow?
Don't have the exact figure, but it was pretty strong.
It's probably our strongest growth. We think the growth there is being driven by some of the catastrophe activity last year, but also just that was a highly competitive area for a long time, and I think, again, when prices get too low, it starts to drive adverse results for insurance companies. As you see poor results give way to carriers exiting the business, tightening up their underwriting standards, and that dislocation creates pretty good opportunities for a company like Kinsale that is in the E&S space.
Right. Great. I think you mentioned that over time, clearly, the E&S market has expanded at the expense of the standard market. Over the last six months, and I know it's market by market, but have you seen, I guess, more prevalence to the standard market coming out of E&S-like risks or more moving into E&S-like risks?
It's just kind of anecdotal, but I would say right now we're seeing business come into the E&S space. It's not that there's not a lot of business going the other direction. It's a pretty dynamic market, of course. In general, we really feel a good sense of optimism, not just for Kinsale's opportunity, but kind of the broader E&S opportunity.
Okay. In the last couple of months, have you brought on any new teams or started any new product areas?
No. No new teams. Obviously, we're always working on product enhancements. That's a normal part of what we do as an insurance company, but no new teams or new divisions in the last six months.
Okay. Then finally, your expense ratio is doing very well this year. Do you think this is a good sustainable level as you grow?
I think so. I think that 25% expense ratio, it's always going to have a little bit of variability to it. I think as the business grows, there's an opportunity to drive that lower. There's also an opportunity now to kind of invest more in the business, and I'm thinking particularly in the technology area, because I think the payback on some of these technology investments is so powerful that might be a little bit more of our focus in the near term as opposed to driving the 25% expense ratio to 23%. We like the idea of reinvesting in our business. We've made a lot of progress over the last nine years in building our system, driving a really superior level of automation, but we also have a long way to go on that front. So I would say we're kind of balancing the two.
Managing our expenses very aggressively, also reinvesting in the business to get even better in the future.
Yeah. Great. Thanks a lot.
Thanks, Adam.
Thank you. We do have a follow-up question coming from the line of Mark Hughes with SunTrust. Your line is now open.
Yeah, thank you. Refresh me on how much competition Lloyd's is relevant to your space at the kind of the smaller end of the market. Do you anticipate any impact on E&S? I think they're going through a restructuring or a strategic review, perhaps. Any observations about their behavior?
Yeah. Lloyd's is pretty significant in many of our lines. I think for the whole E&S space, they're about 23%.
Yeah. Collectively, they're the largest E&S writer by far.
Anything that significantly affects Lloyd's will probably significantly affect the market and then us.
Could it be you're getting some of those larger accounts that might have been Lloyd's accounts before?
The ones that I can think of specifically were not Lloyd's accounts.
Mark, I think typically Lloyd's underwrites larger accounts directly in London. The small accounts where Kinsale focuses, we tend to compete with Lloyd's. Lloyd's delegates underwriting authority to its brokers to underwrite that business on Lloyd's behalf. That's not unique to Lloyd's. I would say probably three-quarters of the business we write, we're competing with binding authorities from our competitors.
That presumably for Lloyd's, would you think that probably has not been a great experience for them, or could that be an area that they'd focus on, perhaps, for some retrenchment?
We've seen a little bit of dislocation in the delegated underwriting authority space, whether you're talking about the contract binding business or larger homogenous programs. Personally, I haven't followed it closely enough to know that, hey, it's Lloyd's specific or it's other carriers. Obviously, we are very partial to our own strategy, which is very different in that we manage and control the underwriting directly. Every piece of business on the books at Kinsale is underwritten by a Kinsale underwriter in our office. We think that's a better model that drives better risk selection and a better result. Lloyd's is like every other carrier we compete with. They contract out the underwriting frequently, because some companies struggle with the cost of underwriting small accounts.
Thank you.
Okay.
Thank you. We have no further questions at this time. I would now like to turn the call back over to Mr. Mike Kehoe for any further remarks.
Okay. Thank you, operator. I think we're all done today, but I want to thank everybody for participating, and I look forward to speaking with you again in three months.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program. You may all disconnect. Everyone, have a great day.