Kinsale Capital Group, Inc. Q2 FY2020 Earnings Call

Ladies and gentlemen, thank you for standing by and welcome to Kinsale Capital Group, Second Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. 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 second quarter 2020 quarterly report on Form 10-Q and the 2019 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 available at the company's website. 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, and thank you for joining us on the call today. With me are Bryan Petrucelli, Kinsale's CFO, and Brian Haney, Kinsale's COO. I will begin the presentation and then Bryan Petrucelli will cover the financial performance for the quarter, and then Brian Haney will provide some color on the market and our underwriting operation. Last night, Kinsale reported operating earnings of $0.84 per diluted share for the second quarter of 2020, up 47% from the second quarter of 2019. Gross written premium was up 41% for the quarter, notwithstanding the disruption of the COVID virus. The company posted an 83.8% combined ratio and a 16.9% annualized operating return on equity for the six months ending June 30, 2020. The Kinsale strategy of disciplined and highly controlled underwriting, combined with technology-driven low costs, and a focus on the E&S market is propelling our profitability and growth. We believe we'll continue to do so over the long term. In addition to our own business strategy, our growth is being enhanced by a growing level of dislocation within the P&C market. After many years of intense competition, some competitors are experiencing adverse results and are withdrawing capacity, canceling some programs, and raising prices. We expect this dislocation to continue, thereby allowing Kinsale to grow at an elevated rate, perhaps through 2021. At some point thereafter, we expect the level of dislocation to abate, and our growth rate to normalize, perhaps in the low double-digit range. Beyond the accelerated growth, industry dislocation is also allowing Kinsale to raise rates and in some cases, restrict coverage to further expand our profit margins. To take full advantage of this market opportunity, there is a possibility Kinsale could raise a modest amount of equity capital before year-end. At the end of the first quarter 2020, we noted that we did not expect the COVID-19 virus to have a material impact on Kinsale’s profitability or growth. Three months later, we have the exact same position. The temporary drop-off in March in the growth of new business submissions reversed within a couple of weeks, and we have experienced a V-shaped recovery in submission activity and premium. On the claim side, three months ago we noted a small number of claims where all policies involved had coverage exclusions that we anticipated would preclude any payout. We are essentially in a similar place today, with a small number of claims against policies with coverage defenses in place, and we don't see any material impact to either growth or profitability arising from the COVID-19 virus.

Thanks, Mike. The premium growth and the profitability that Mike just mentioned is encouraging, given the less-than-ideal economic conditions generated by COVID-19 in the second quarter. Just as a reminder, our primary goals as a company are to consistently produce mid-80s combined ratios and mid-teens operating returns on equity, and our second quarter 83.9% combined ratio and 16.9% annualized operating ROE are right in line with that guidance. We reported net income of $30.3 million for the second quarter of 2020, representing an increase of 120% when compared to $13.8 million last year. Net income this quarter included approximately $13 million in pre-tax unrealized gains on our equity investments, as the financial markets came back our way and recovered nicely from the significant declines in the first quarter that were driven by the equity markets' reaction to COVID-19. Net operating earnings, which exclude the volatility from the investment gains and losses, increased by 54% up to $19 million compared to $13.5 million in the second quarter of 2019. The company generated underwriting income of $15.7 million and a combined ratio of 83.8% compared to $10 million and 84.8% last year. The combined ratio for the second quarter of 2020 included 3.7 points from net favorable prior year loss reserve development compared to 2.2 points last year. Our effective income tax rate for the first six months of 2020 was 14.8%, and again includes discrete tax benefits recognized from the exercise of stock options during the period. Gross written premiums were $134 million, representing a 41% increase over last year, for all the reasons that Mike previously mentioned including continued market dislocation and sustained service levels. On the investment side, net investment income increased by 38% over the second quarter last year, up to $6.6 million from $4.8 million last year, as a result of continued growth in our investment portfolio. Annualized gross investment returns excluding cash and cash equivalents did decrease to 3% from 3.2% last year, just given the lower interest rate environment. Diluted operating EPS was $0.84 per share for the quarter compared to $0.57 per share last year. And with that, I'll pass it over to Brian Haney.

Thanks, Bryan. As mentioned earlier, premium grew 41% in the second quarter, which is lower than the 47% growth rate in the first quarter. There are two big competing factors that have been affecting our growth rate: the hardening E&S market and the COVID-related lockdowns. The bulk of the effect of COVID was felt in the second quarter, that peaked or bottomed out depending on your perspective in April. Since then, we've seen significant recovery in the growth rate. Anecdotally, I could say that the growth rate in June was essentially the same rate as the growth rate in January. So while COVID is undoubtedly still weighing on economic growth and our opportunity somewhat, that effect is being overwhelmed by the impact of the hardening of the E&S market. I would say at this point, all of the markets we compete in are trending in the direction of improvement more than others. The excess casualty, commercial property, and allied health spaces are probably in the vanguard of market hardening. Years of bad underwriting and overly aggressive behavior in the market have led to seriously poor results and forced the more undisciplined among the competition to significantly pull back. Some competitors have been compelled to dramatically increase their rates, which had been inadequate for many long years of the soft market. They've also had to tighten terms and conditions, re-underwrite some books of business, reduce limits, exit some classes of business entirely, and terminate some programs. All of this has led to more opportunity for us. We have maintained underwriting discipline throughout the soft market, so we are not now being forced to pull back in the hardening market. Submission growth was 24% in the second quarter, down slightly from 25% in the first quarter. But as I mentioned earlier, the COVID effects were worse in April. Based on what we saw in June, we believe growth rates and submissions have essentially returned to pre-COVID levels, even though there's undoubtedly still some ongoing effect from the lockdowns. As for rates, we are still pushing them up in response to market conditions. As a reminder, we have a very heterogeneous book of business, which complicates reducing all the rate movements to one single number. But that all being said, we see rates being up in the 10% to 12% range in the aggregate during the second quarter. What is not reflected in this 10% to 12% rate increase, however, are terms and conditions. As the market has hardened, we have also been pushing for more favorable terms and conditions. Even though that may not be reflected in rate changes, it does affect profit margins. So we expect that the 10% to 12% might understate the change in profitability in the book. And with that, I'll turn it back to Mike.

Thanks, Brian. Operator, we're ready to open up the line for questions now.

Thank you. Our first question is from Matt Carletti with JMP Securities. Please go ahead.

Hey, good morning.

Good morning, Matt.

Mike, I appreciate your and Brian's comments regarding submissions and premium growth returning to pre-COVID levels. Could you provide some insights into what you observed during the quarter, particularly in April, May, and June? Additionally, if you have any preliminary information about July, I would be interested in understanding the progression.

Yeah, we touched on this the last conference call that at its most severe moment, our growth rate in new submissions went from the high 20s to low 30s down to about 2% to 5%. Right, so we saw this dramatic drop-off in the growth rate. But that was for a couple of weeks and then there was a kind of a V-shaped recovery, if you will. Premium was never that dramatic; I mean premium, you know, we don't track the premium by day and we don't have that detail to provide. But on a monthly basis, you didn't see nearly that kind of drop in premium.

Okay, great. And then just one other one, I had a question on the expense ratio was, you know, you took a nice step down in the quarter. And just curious, are there any kind of one-time or we're seeing that in some of the companies, kind of COVID-related benefits there? Or is that just the leverage in the model as the earned premium catches up with the gross written, you're getting expense ratio leverage on the bottom line?

I'm going to let Bryan Petrucelli handle that one.

Yeah, Matt. That's exactly what you're seeing. You know, we are hiring folks in our underwriting and claims and IT area just to kind of keep up with our growth, but it's at a much lower rate than what we're seeing from a premium growth perspective. So I think you could be seeing some economies of scale there.

Great, thank you. Well done and best of luck going forward.

Thanks, Matt.

Thank you. Our next question comes from Mark Hughes with SunTrust. Please go ahead.

Yeah, thank you. Good morning.

Good morning, Mark.

And Brian Haney, you had suggested June was back to January levels or as comparable to January. Do we assume that sort of the 47% premium growth you had in Q1, is that kind of what you're saying?

We don't have those details to provide. I was just giving that just to put in context what Mike was saying about how growth rates had recovered.

Right. So June being better than the quarter as a whole?

Yeah.

And somewhat similar January is your point?

Yeah, June was much higher than April and May then.

Yeah. And that same momentum presumably continues into July, is it?

I don't think we're ready to comment on the third quarter yet. However, if you refer back to my earlier remarks, we have a degree of optimism about the direction of the hardening E&S market. We believe we have a strong opportunity ahead, particularly through 2020 and possibly into 2021. That said, we prefer not to discuss the specifics of the third quarter at this time.

Understood. How about in terms of claims activity, both new claims on the current year and then what you've seen on the older claims, how they develop through this period with the courts shut down, etc.?

We don't have any significant updates regarding material changes. Generally, the courts operate differently by state and sometimes even within the same state, which affects the interruption processes. Overall, the courts have been mostly closed. While we don't litigate a large number of cases, the slowdown in the court system has likely had a slight impact on how quickly claims are being resolved. We make sure to account for these adjustments in our reserve calculations. We often mention our aim to maintain conservative reserves that are more likely to develop favorably, and we believe we are well on track to achieve that. There is likely some slowdown occurring, but we are still managing to open new claims and conclude old ones at a reasonable pace. That's how I see it.

Understood? And Q1, you talked about putting an extra amount into IBNR, I think related to the current accident year, any dynamic like that this quarter?

In the first quarter, we examined the details due to the significant impact of the virus on the economy, which raised concerns among investors regarding its effects on the property and casualty industry. While I don’t anticipate delving into such detail in every quarterly call, I can mention that we allocated approximately $5.4 million in Q1 related to the uncertainties that arose from COVID, rather than direct effects of the virus itself. The overall impact on the industry, the shutdowns, and the economic fallout contributed to this reaction. However, I believe Kinsale has steered clear of business lines that face significant exposure to litigation or claims stemming from the virus, such as mortgage insurance and event cancellations. Our focus is primarily on commercial property, which is primarily industrial in nature, meaning most of our insured clients did not experience shutdowns in the same way that restaurants and hotels did. Moreover, we have stringent coverage defenses in place. Considering all these factors, we don’t foresee any material impact on our business concerning our loss ratio or growth. We consistently aim for conservative reserving, and this approach remains true for the second quarter, just as it has been for every other quarter.

One final question, if I might. The excess casualties was one of the areas where you're seeing a lot of opportunity. Would you anticipate outsized growth there, and does that have an impact on the seeded premium ratio?

I'm going to turn that one over to Brian Haney.

To some extent, if that growth surpasses the growth of the rest of the portfolio, then yes. However, allied health is also experiencing growth, and there are other areas that are seeing significant growth as well. So, it’s difficult to determine definitively; it’s possible.

No obvious mix shift?

No.

That’s good.

Now, though, I mean, because basically, everyone's growing. It's just a question of how fast.

Yeah, okay. Thank you very much.

Thanks, Mark.

Thank you. Our next question comes from Rowland Mayor with RBC Capital Markets. Please go ahead.

Good morning, guys.

Good morning.

So a couple quick ones on the balance sheet. First, can you remind us, within that other liabilities line, why it’s gone from, you know, less than $1 million to $20 million this year?

Bryan?

Yeah, this is Bryan. That includes things like securities payable. There are some liabilities in there with respect to the building; you know, that's our headquarters that's currently under construction. And that's really the majority of that.

Yeah, it makes sense. And that headquarters is still on track to be done sort of in Q3 and there's been delays?

Now we're largely on target, I think. And Mike, you correct me if I've got this wrong. I think we're looking at sort of mid-September-ish, mid-September or late September to complete that.

Got it. And then one last final one. The investment portfolio duration is up a bit, and critical is down a bit from year end, anything notable going on there, and should we get used to that longer term?

I think it's just a modest adjustment in our portfolio to take advantage of some of the dislocation that you saw in the markets related to COVID. I wouldn't expect any dramatic change in duration going forward.

Got it. And is equities still going to be about 10% of the portfolio, or are you seeing opportunities there?

Yeah, I wouldn't expect too much of an increase there. We did add to our position a little bit to take advantage of the severe decline in the market in the March-April timeframe, but I wouldn't expect it to increase much more than 10%.

Okay, perfect. Thank you for your answers. That was all I had.

Sure.

Thank you.

Thank you. And our last question is from Jeff Smith with William Blair. Please go ahead.

Hi, good morning.

Good morning.

I came on a little late but did you touch on or could you touch on the rate increases you're seeing in some of your lines of business?

Yeah, Brian Haney, do you want to take that one?

Yeah, I think what we said was the rates are up 10% to 12% in the aggregate. You know, we don't generally go into detail about differences in lines, but I would say that, I mentioned that the allied health, management liability, commercial property, and excess casualty spaces were more hard than others. So you can infer that those rates are going up higher than average.

Okay. And then you've historically been kind of conservative with loss picks in the first half. I mean, it seems like that was the case here with Q1 in particular. And then you'd see sort of lower picks in the second half; is there anything that would change that this year or do you think that will be the case?

Yeah, I don't know that we have any kind of real seasonality to our loss reserving. I think, you know, our goal is of course to put forth our best estimate but tempered with a very strong measure of conservatism to account for the fact that it can be an uncertain business. And, you know, we really strive to be conservative and cautious in how we set those estimates. We want investors to have a lot of confidence in our balance sheet. In general, I think we've been successful. We're not a company that's been around for decades, but we are in our 11th accident year now. And all of our accident years except for 2011 have developed favorably on an inception to-date basis. So, I think we've got a good track record and we're looking to build on that. Bryan Petrucelli, would you add anything to that?

Yeah, I think that's a good way to describe it, Mike.

Okay. And then what was the impact of exposure on GPW growth in the quarter?

Brian Haney, you want to take that?

Yeah, we don't have those exact figures. I would just be speculating if I answered it. I would say, it was probably had probably less of an impact. Or let's put it this way, exposure growth probably contributed less to our growth in the second quarter than it did in previous quarters because of the effects of COVID.

Right, but it wasn't negative; it remained positive, don't you think?

I think it remained positive because most of the businesses we insure didn't actually shut down during the lockdown.

Okay. Okay, thank you.

Thank you. And this concludes our Q&A session for today. I would like to turn the call to Michael Kehoe for his final remarks.

Okay, well, thank you operator for organizing the call, and thank you for everybody who participated. We look forward to speaking with you again here in a few months. Have a great day.

And with that, we thank you ladies and gentlemen for participating in today's conference. You may now disconnect. Have a great day.