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 would 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 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, welcome everybody to the Kinsale call. Also joining me this morning are Bryan Petrucelli, Kinsale's Chief Financial Officer, and Brian Haney, Chief Operating Officer. Bryan Petrucelli is going to follow me to detail the numbers for the quarter. Brian Haney will follow up with some color on the market and Kinsale's underwriting operation. The Kinsale strategy is to combine disciplined underwriting and claim handling with technology-enabled low costs to deliver attractive returns and growth to our stockholders, even in a competitive market like we have today. Disciplined underwriting for Kinsale starts with a focus on a higher margin segment, like smaller account excess and surplus lines. It includes our maintaining absolute control over the underwriting and claim handling process and not outsourcing those functions to external parties. It involves targeting hard-to-place accounts that frequently drive better risk-adjusted returns.
It means carefully managing the coverage we offer and making sure to minimize inaccuracies in the underwriting process. All these elements of Kinsale's underwriting strategy help drive the favorable loss ratios we've achieved. On the expense side, Kinsale operates at a significant advantage over older legacy companies by using one end-to-end enterprise system to operate our business. Kinsale has no legacy systems that date back decades like many of our competitors do. The Kinsale enterprise system was built by our developers and analysts specifically for our company. We own the source code. This technology and automation drives efficiency and accuracy in our business, as well as superior customer service and data collection. More importantly, having one end-to-end system allows for the rapid rollout of new features and functions to continue to improve Kinsale's operating performance going forward.
This system advantage, combined with our entrepreneurial business culture, allows Kinsale to operate at expense levels of 25%, in some cases 30% or even 35% lower than many of our competitors. Low costs allow Kinsale to offer more value to the customer while at the same time providing robust returns to our stockholders. Combining disciplined underwriting with low costs is an end game winner every time. Kinsale had a respectable start to 2018 with a combined ratio of 85.9% and an operating return on equity of 13.7%. Net operating earnings were up 30.3% over the first quarter 2017, and gross written premium was up almost 21%. For more detail on our financials, I'm going to turn the call over to Bryan Petrucelli, Kinsale's CFO.
Thanks, Mike. As Mike noted, we feel pretty good about the first quarter results. I first just want to start by pointing out the adoption of the new accounting standard this quarter, where unrealized gains and losses associated with our equity investment portfolio are now recorded through our income statement. Previously, such changes were recorded through other comprehensive income. This increases a little bit of volatility through our income statement. Changes in unrealized gains and losses associated with our fixed income investment portfolio continue to be reported through other comprehensive income. For purposes of comparability with previous periods, we've now introduced an operating earnings metric that normalizes for the unrealized gains that are flowing through our income statement. Now on to results for the quarter.
We reported net income of $7.3 million for the first quarter of 2018, which is an increase of 16% over the $6.3 million reported last year. Net operating earnings increased by 30.3%, or $8.2 million compared to $6.3 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 17.3% for the first quarter of this year compared to 32.4% last year, and was lower due to the impact of the Tax Reform Act that was enacted in December of last year and the recognition of tax benefits from stock options that were exercised during the period. The company generated underwriting income of $6.8 million and a combined ratio of 85.9%, compared to $7 million and 82.6% last year.
The combined ratio for the first quarter of 2018 included 2.7 points from net favorable prior year loss reserve development, compared to 12.6 points last year. There was no meaningful cat activity this year or last year for the first quarter. Annualized operating return on equity increased to 13.7% for the first quarter of 2018, compared to 11.8% last year. Gross written premiums were $63.8 million, representing a 20.8% increase over the first quarter of 2017, and continues to be generated from an overall increase in underwriting activity across most lines of business. Brian Haney will get into this in a little more detail here in a bit.
On the investment side, net investment income increased by 41.3% over the first quarter of 2017 to $3.2 million from $2.3 million last year as a result of continued growth in the investment portfolio, rising interest rates, and by taking a little more risk in our investment portfolio. Annualized gross investment returns increased to 2.7% from 2.3% last year. From an EPS perspective, basic and diluted EPS, operating EPS was $0.39 and $0.38 per share respectively, compared to $0.30 and $0.29 per share respectively last year. With that, I'll pass it over to Brian Haney.
Thanks, Bryan. As mentioned earlier, premium grew almost 21% in the first quarter. 15 of our 17 divisions grew, some of them substantially. Our commercial property division in particular grew strongly due in part to the large influx of submissions we've seen since last year's hurricanes. Our allied healthcare division was also up nicely for the quarter. This market has seen a lot of dislocation, with a number of our competitors having to re-underwrite their books of business. On the other hand, the construction market was very competitive in the quarter, and the healthcare space continues to be very soft. Submissions in the fourth quarter were up slightly less than 20%, which is right around where it has been for the last three quarters.
We look at submissions as a good leading indicator for where the business is headed, it's a positive sign that submissions are up in every one of our 17 divisions. We continue to focus on improving our internal processes to drive down the time and cost of quoting. This allows us to quote more business and quote it faster. It also allows us to write smaller deals than our higher expense competitors would be able to write economically. This emphasis on superior customer service is allowing us to grow without compromising our margins in what is still a very competitive market. Moving on to rates, we continue to increase rates selectively. We've pushed up technical rates on some classes in the first quarter, and we expect to do more of that in the second quarter and throughout the year. It's still modest at this point.
The rate increases by division are generally +5% or lower, still positive overall. In general, the market seems to be in a state of flux. While prices are going up mostly, they're not quite going up as fast as we would hope or would have expected. We are seeing more and more accounts, and in some areas, the competition does seem to be less pronounced. Overall, the industry rate changes in the commercial property space, while positive and a good sign, are just not quite what they ought to be. The industry as a whole needs more significant rate increases in commercial property and many other areas, we think that eventually will have to happen. When it happens, we don't know, but we feel confident it will happen. With that, I'll turn it back over to Mike.
Thanks, Brian. Operator, we're ready to field any questions now.
Thank you. Ladies and gentlemen, if you would like to ask a question at this time, please press the star and 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 is star then one to ask a question. Your first question comes from the line of Mark Hughes with SunTrust. Your line is open.
Yeah, thank you. Good morning.
Good morning, Mark.
In the allied healthcare area, are the loss trends relatively stable? Sounds like there's a lot of dislocation. Is that because of bad pricing or is it because the loss environment is volatile?
I think there've been a lot of companies that got off track by being overly aggressive in the accounts that they pursued. We've seen some large MGA programs either be cut back or been canceled. We've seen companies actually withdraw from the market in some respects. One area where for a number of years Kinsale didn't write any business, would've been skilled nursing homes. Now that we're seeing people exit that space, we're able to selectively find some accounts to write. It's a large industry segment. I think with the dislocation, there's a rise in opportunities for us to find attractive business to write.
Yeah. Current accident year loss pick was definitely down substantially from last year. I know there was some discussion of some seasonality in that perhaps that you were a little more conservative in Q1. As the year progressed, you reevaluated. That ended up last year being a favorable pattern. You started out lower this year. Could you talk about what you're seeing, what approach you're taking?
Yeah, I think most of the delta between the current accident year, at the end of first quarter 2018 versus 2017 is just a variation in our reported losses. Again, you've got a certain amount of volatility in the case basis reserves and the claim payments in a 90-day period of time. I think we ended 2017 right around a 60% accident year loss ratio. We would still expect the first quarter number to trend down slightly over the course of the year.
How about reserve development? It definitely got back into the black after Q4, a little more moderate pace than we might have seen historically. How are you seeing reserves?
Yeah, I think we detailed some of that in our MD&A. The 2017 and 2016 years developed favorably. There was a little bit of movement in some of the older accident years. I think it's important to reiterate that the Kinsale strategy, of course, is to be conservative in how we post reserves. We want there to be a greater probability that the reserves develop favorably than unfavorably. I think if you look at our, we're in our ninth accident year today, if you look back over the history of the company, every accident year except one, on an inception to date basis, has developed favorably. I think we're on the right track. The fact that we see a little bit of volatility in some of those earlier and smaller accident years, doesn't change our evaluation of where we stand. We feel good about the reserves.
And then-
feel good about the reserves.
Thank you. Last question, on pricing, I think you suggested 5% or lower, generally speaking, and you'd like to see more, but I think you also said you expect to see more rate increases as the year progresses. Do you think, is that to say we'll be in this kind of plus 5 range through the balance of the year, or do you think it could get a little bit better?
It's tough to say. I would say definitely the industry needs to push rate more, we're going to push. We're basically a price taker when it comes to the market. We're not big enough to drive rate ourselves. The industry needs to push rate up more. I would expect that to happen, and I would expect us to push rate up along with the industry. The rate change we took, we feel very comfortable with. The market is bearing it, I think it's allowing us to hit our targets.
I think, Mark, it's also worth reiterating the fact that Kinsale operates at this fairly dramatic expense advantage over a lot of our competitors. Gives us a lot more flexibility to operate in a competitive environment and not compromise the returns that we're achieving for our stockholders.
Thank you.
Thank you. Your next question comes from Jeff Schmitt with William Blair. Your line is open.
Hi, good morning everyone.
Good morning.
The adverse development, I guess looks to be about $2.4 million for the 2011 through 2015 accident years. Which lines were those?
We've got nine, I think we have nine or 10 statutory lines of business. We've got nine accident years. Those estimates shift around from time to time. In general, I would say, hey, there's really no pronounced trend that we're concerned about. As I said to the previous caller, on an inception to date basis, all of those accident years except one have developed favorably. The one year that developed unfavorably is the 2011 year, and I think we originally, just to kind of put the size of the book of business back then in context, we originally booked those reserves at, I think it was about $12.4 million, and I think they've developed up to about $14 and a half million, give or take. Right. Again, some of those early years were very modest in size. There's no concern around pernicious trends.
They've all developed favorably except the one year on an inception to date basis. We feel very positive about how conservative the company's reserves are stated.
Okay. How is growth of Aspera looking, and what's the size of that book now?
I think that's disclosed in the Q. It's a little bit under 4%. It's growing rapidly, from obviously a small base. A lot of that growth is geographic, as we expand into new territories. Some of it is expansion of the line of business into new products. Aspera, I think, plays into the Kinsale growth story in that it's driving some diversification in our distribution channels.
Mm-hmm. Okay. I guess the tax rate lower than we would've expected. What do you see that as going forward? Will it be closer to 21?
I think it's going to be a little less than that. I think the impact from the stock option exercises was about 2%. That would get you to about 19.5%, I think, on a run rate basis.
We're going to have some stock option exercises every quarter. It's just a little difficult to predict, but I think if you strip that out, it comes out to about 19.5%.
Yep. Okay, great. Thank you.
Thanks a lot.
Thank you. Your next question comes from Mark Dwelle with RBC Capital Markets. Your line is open.
Yeah, good morning. Apologize if you went over this a little bit, I've been bouncing between a couple of different calls here. On your current accident year, that improved by about four points, give or take. Is that primarily a mix question, or because of better pricing, are you able to make lower loss picks? Can you just talk through the process there a little bit?
Yeah. Mark, good morning. It's Mike. A little of it may be mix, right? We're seeing some fairly rapid growth in our property lines. That's the commercial property, that's the personal lines book, which is homeowners for manufactured homes. It's our inland marine book. Most of it is just a variation over a 90-day period of time in the reported losses, right? It's case reserves and it's paid claims over a 90-day period is going to bounce around a little bit. That's the most significant piece of it. I think we finished 2017, if you just look at the accident year, right around a 60% loss ratio. In terms of where we see that trending, that's where we'd hope to trend again this year.
Okay. That's helpful. The second question I have is, obviously your growth has been excellent over the last several quarters. You're up to kind of a gross premium run rate in the, call it, mid $60 million kind of range. As you look ahead, if you're able to continue at that sort of a growth rate for the balance of the year, it would triangulate to maybe $250 million of annual premiums. At what point do you start to become capital constrained as far as a gross premium to surplus ratio or need to consider whether it be debt or any other type of an instrument to try to get a little bit more capital underneath your growth?
I think, obviously we monitor and manage the capital very carefully, with an eye toward maintaining our AM Best rating of A minus. That's critical to us. I think, given the primary proceeds we raised in our IPO in the middle of 2016, we're still in good shape, throughout 2018. I think there's a chance we would borrow some money beyond that. We think having a little bit of financial leverage in our balance sheet will help boost returns, and that's a fairly inexpensive form of capital for us, even with rates rising a little bit of late.
Okay, thanks. I guess the last question I had, you mentioned in your opening comments about adding a little bit of risk to the investment portfolio and so forth. Can you just elaborate there a little bit about what you're thinking about?
Last year, we took out our duration a little bit. I think we used to be around three years.
Yeah, we're closer to four now.
Now we're running about four years on the duration. I think we had a small allocation to preferred stocks, some structured securities. It's still a very conservative portfolio. I think it's double A credit quality on the fixed income. In terms of common stocks, I think we've got maybe a 5%, 6% allocation there. It's just that it's kind of an incremental expansion in the risk appetite, just trying to augment returns a little bit.
Okay. Yeah, I definitely agree. It's still a very conservative portfolio. Is the four-year duration now, that's probably pretty close to your liability duration?
Yeah.
Yeah.
Okay. That's all my questions. Thanks.
Okay. Thanks, Mark.
Thank you. I'm showing no further questions at this time. I'd like to turn the call back over to Michael Kehoe for closing remarks.
Okay. Thank you, operator. Thanks everybody for joining us on the call, and I look forward to speaking to you again in a few months.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you all may disconnect. Everyone have a wonderful day.