Kinsale Capital Group, Inc. Q2 FY2021 Earnings Call

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 2020 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 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. We appreciate your joining us on the call today. Bryan Petrucelli, Kinsale's Chief Financial Officer, and Brian Haney, Chief Operating Officer, are with me as well. After each of us make a few comments we will then take any questions you may have. Kinsale's operating earnings for the second quarter 2021 were $1.28 per diluted share, an increase of 52% from the second quarter of 2020. Gross written premium was up over 45% for the quarter. The company posted a 79.5% combined ratio and an 18.2% annualized operating return on equity for the first six months of 2021. These numbers are well ahead of our guidance of a mid-80s combined ratio and mid-teens operating return on equity. Kinsale's results were driven by our unique business strategy that combines a focus on the small account E&S market, control over our underwriting operation, and technology-enabled low costs, but they are also driven, especially the 45% growth rate in the second quarter, from the continued favorable market conditions within the E&S segment. We continue to see steady growth in new business submissions, which we see as a bit of a leading indicator, and we continue to see low double-digit rate increases across the book of business, which are positively impacting our margins. Brian Haney will offer some additional commentary on this topic here in a moment. We are optimistic about market conditions for the balance of the year and perhaps next year as well. Regarding capital levels, the company is well situated currently, and we don't expect to need any additional capital this year even with the strong growth rate. To the extent that we do need additional capital next year, we would expect to use debt in lieu of equity capital. I'll now turn the call over to Bryan Petrucelli.

Thanks, Mike. The results for the second quarter continue to be strong and driven by solid premium growth, favorable loss experience, and disciplined expense management. We reported net income of $35.6 million for the second quarter of 2021, representing an increase of 17.8% when compared to $30.2 million last year, primarily due to higher earned premium and net favorable loss reserve development. Net operating earnings increased by 54% to $29.4 million, up from $19 million in the second quarter of 2020. The company generated underwriting income of $28.7 million and a combined ratio of 79.2% for the quarter, compared to $15.7 million and 83.8% last year, with improvements to both loss and expense ratios. The combined ratio for the second quarter of 2021 included 6.6 points from net favorable prior year loss reserve development and 2.1 points from natural catastrophe losses, compared to 3.7 points of favorable loss reserve development and negligible natural catastrophe losses last year. The natural catastrophe losses this quarter were primarily related to development on losses from a couple of the Texas winter storms. Our current accident year loss ratio exclusive of natural catastrophe losses decreased slightly in recognition of ongoing favorable pricing trends that Mike previously touched on. We expect there will always be some variability in our quarterly expense ratio, and our 21.7% expense ratio for this quarter continues to benefit from some economies of scale, given that our earned premiums are growing faster than our operating expenses and from slightly lower relative net commissions as a result of a shift in the mix of business to lines that are subject to reinsurance and where we receive ceding commissions. Our effective income tax rate for the quarter was 18.5%, compared to 14.8% last year, and higher due to lower tax benefits from stock compensation activity this quarter. Annualized operating return on equity was 18.2% for the first six months of this year, and again, as Mike stated, ahead of our mid-teens guidance. Gross written premiums were approximately $194 million for the quarter, representing a 45% increase over last year, due to the favorable market conditions that Mike mentioned and also our superior service standards. On the investment side, net investment income increased by 11.8% over the second quarter last year, up to $7.4 million from $6.6 million last year, as a result of continued growth in our investment portfolio. Annualized gross investment returns excluding cash and cash equivalents was 2.6% for the year so far compared to 3% last year. Diluted operating earnings per share was $1.28 per share for the quarter compared to $0.84 per share last year. And with that, I'll pass it over to Brian Haney.

Thanks, Bryan. As mentioned earlier, premium grew 45% in the second quarter, up from 36% in the first quarter and 34% in the fourth quarter of 2020. The growth is generally driven by higher submission volume and rate increases, as well as robust economic growth, which is driving up premiums. Every one of our divisions was up for the quarter, led by allied health, excess casualty, and commercial property. The reopening of the economy and the strong economic growth is providing us a significant boost. Submission growth was in the upper teens in the second quarter, which represented a rebound from the first quarter. As for rates, we continue to push them up in response to market conditions. As a reminder, we have a very heterogeneous book of business which complicates reducing all the rate movement to one single number. But that all being said, we see rates being up in the low teens range in the aggregate during the second quarter, generally consistent with the past two quarters. Some data suggest that the industry is past peak rate increases at this point, but for whatever reason, perhaps the mix of business, we feel that our rate increases have stayed high and not started to ebb. It is worth discussing inflation for a moment. It's important to note that a majority of our policies are written on inflation-sensitive exposure bases such as revenue or payroll. So, as inflation goes up, premiums go up commensurately for the bulk of our policies. Inflation also affects losses, of course. And while our loss trends have been tamed, we are noticing a general price inflation for the businesses we insure and the economy on the whole. It is a matter of time before that shows up in loss trends for us and the rest of the industry. The biggest components of our losses are medical costs, lost wages, construction costs, and legal costs, all of which are going to be affected by general price inflation. We are aware of this and staying on top of it. Whatever the true inflation rate is and whether or not it is transitory, we are getting rate increases that are in excess of it, so we are implicitly building on what we're already strong margins. We feel that elevated inflation will prolong the hard market because it will erode the margin improvement that insurers were aiming for with the increased rates. We feel we are in a good spot because we are raising rates not to correct the problem, but to further improve our already strong returns. In any event, the longer inflation remains elevated, the longer we expect the hard market will stay with us. In summary, we are optimistic. We have a great team, great results, as well as a strong balance sheet with conservative reserves. Our business model works well in any market, hard or softer in between, but the current market conditions are really good. And with that, I'll turn it back over to Mike.

Thanks, Brian. Operator, we're now ready to take any questions that come in.

Thank you, sir. We have our first question from Jeff Schmitt at William Blair. Your line is open.

Good morning, Jeff.

Hi. Good morning. Just curious how you handle inflation from a reserving perspective. I think you'd have to have a view on whether it's sort of transitory or not. You tend to be pretty conservative. Just wondering how you're accounting for that?

Yes. I mean, I think we've spoken about this many times that it's a fundamental part of our business strategy to post reserves that are much more likely to develop favorably than unfavorably. And we're constantly reviewing actual experience against all the various actuarial assumptions including loss cost trends. And so, as data comes in, we adjust our estimates accordingly. As Brian said, most of our policies are priced off of inflation-sensitive metrics. So, to the extent inflation picks up, that flows through the revenue that our insureds experience and our insurance premiums are priced off that inflated base. But does that kind of get at your question?

I was just wondering if you have to decide whether that's a temporary situation or how you approach it. You mentioned that some of the fastest growth is in allied health and excess casualty. Are those areas the most distant from rate adequacy, or is there just more disruption in those lines? Could you elaborate on that?

I would say that the rates we're charging in those areas are sufficient, and we are achieving a very high margin. However, the industry has faced some challenges in these areas. Commercial property has experienced a significant amount of catastrophe activity. In allied health, several competitors have struggled and exited that line of business. Excess casualty is often seen in a market adjustment when participants get hurt by overly lenient practices and then have to adjust accordingly, and that’s what we are witnessing. Nevertheless, we feel confident about our rates and our performance in this sector.

I was referring more to the market, particularly in areas where it seems to be lagging. You've maintained adequate rates for some time, so thank you for the answers.

Thank you. We have another question from the line of Mark Hughes from Truist. Your line is open.

Yeah. Thank you. Good morning.

Good morning, Mark.

The 210 points of development on the Q1 storms was that inflation material costs higher than expected, or what drove that?

I think it was a couple of claims where we were in an excess position. And on a larger commercial schedule, there can be some ambiguity in the early days. Hey, we think this loss is $30 million. And over the course of the adjustment process, it turns out to be a higher number and if we're attaching excess of substantial retention, or an underlying schedule. I think it was that type of thing. I wouldn't attribute it to inflation per se. I think it was just ambiguity in the adjustment process and we were in an excess position.

Understood. When we consider social inflation, you've mentioned it several times. Do you observe any changes in the court systems or any impacts on your portfolio? I believe you generally avoid those matters, but could you provide us with some insight into the current activity or developments in the courts?

I believe the loss cost trend is significant, and we aim to stay ahead of it. Our focus on smaller commercial accounts and lower limits provides some protection from extreme verdicts. Regarding inflation, as Brian mentioned, we will experience general price inflation like everyone else. Property claims are being affected by rising material and labor costs, which we are witnessing in our current estimates. However, I don't think this is affecting our overall trends across our entire portfolio. Things are proceeding well for us.

And then the reserve development in the quarter, the 6.6 points, how much of that was 2020? 2020 was obviously an unusual year in terms of frequency and severity a little more depth. I know in some of your older accident years, you've had some less favorable development through time. How are you seeing that dynamic now?

We are conservatively positioned across all of our accident years, which is a top priority for our management team and the business as a whole. Over the last couple of years, we have seen significant rate increases, and I would say the more recent accident years are even more conservatively positioned. The year 2020 also presents challenges due to COVID, resulting in reported losses that were lower than anticipated. We addressed this by increasing our IBNR to ensure we are prepared for any potential rebounds in reported loss activity. As each quarter passes, we will make slight adjustments to our assumptions to align the 2020 accident year with previous years. Generally, we continuously review actual loss activity against our actuarial assumptions and make necessary adjustments. From an investor perspective, I would point out that we are noticing a slight increase in the amount of redundancy each quarter, largely due to the significant price increases we have implemented recently. Overall, we feel very confident about the company’s reserves and the modest margin expansion that is beginning to reflect positively on our bottom line.

Have you seen any bounce back off the 2020 accident year in terms of claims?

No.

Okay. And then one final question. I'm sorry to go on, but Ryan Specialty's IPO discussed that there is consolidation among the wholesale brokers. Do you have any thoughts on whether that is true and what it might mean for your ability to access the market?

Well, there's definitely been consolidation. Ryan has acquired a number of firms, but the others have as well, and it hasn't had any impact on us. We do quite a bit of business with all the large wholesale brokers. But we work with a lot of smaller ones. We kind of characterize them as national brokers. Some are more regional, some are very local. There are some start-ups that have opened in the last couple of years. We work with them as well. But certainly there's been a lot of acquisition activity, and as of today, it hasn't really impacted our business. So, we do quite a bit of work with all those firms and they're very good at what they do.

Thank you.

Thank you, sir. We have another question from the line of Casey Alexander from Compass Point. Your line is open.

Hi. Good morning. I have a couple of questions for you. First, given the extraordinary growth rate that you're achieving, to what extent does this eventually put pressure on your workforce, your real estate footprint, and your need to increase expenses to support this growth? Additionally, particularly regarding the real estate aspect, how do work-at-home habits and changes in those habits affect that situation?

Casey, good morning. This is Mike. Yes, we've been growing at a strong double-digit rate for a number of years now. And of course, it puts a lot of stress on your management team. We're recruiting and hiring a lot of people. There's a big training component and the like. But hey, that's what we get paid to do, and we've been working hard at it for a number of years now. So, that's kind of business as usual. In terms of the real estate footprint, there's no stress there. We've got plenty of capacity in the building that we occupy. What was the third part of your question?

Well, just how this work-at-home habits impact that?

Yes. We're a work-from-the-office team and we did move 90% of our employees home when the virus first hit back in, I guess it was March or April of 2020. But by October, we were basically back in the office and given the number of new hires, the training component. We want those new employees to learn our culture. Working together in an office facilitates communication. A big part of our business strategy is delivering best-in-class service to our brokers. And all those goals are furthered by having everybody work together in an office. And so, that's how we're operating.

Okay, great. Thanks. And secondly, I would say, a year ago the discussion during the quarter you discussed that a decrease in the competitive environment and in the set of competitors was offered you kind of a clear vision towards accelerated growth over the course of the next year. How would you characterize the competitive environment now compared to what it was a year ago?

I'd say, it's pretty flat. So, we've seen some new competitors but they tend to be small, and we've still seen some pullback from larger competitors. So, on balance, it's more or less the way it was.

All right. Great. Thank you. I appreciate you're taking my questions.

Thanks, Casey.

Thank you, sir. We have another question from the line of Rowland Mayor from RBC Capital. Your line is open.

Hi. Good morning. When you guys talked about low-teens rate increases, is that pure rate or the effects of changing terms and conditions included in that number?

It's pure rate.

Not including the effect of inflation on the exposure base.

Got it. And is there any way to quantify sort of the impact of your tightening terms and conditions and say is that worth another one or two points, or is it the equivalent of one or two points of pricing or any...

It would be tough to quantify. It's worth something.

Got it. That was my next question. To echo Casey's comment, we've heard many companies discuss increasing growth. Do you expect that in the upcoming quarters? It doesn't seem like it's affected you at all, has higher competition not reached your market yet?

There is a significant amount of competition. Brian mentioned that it has remained consistent compared to last year. Our success rate for new business submissions is still between 10% and 15%, just like last year and the year before. While it's true that competition has lessened compared to four or five years ago when the market was more intensely competitive, it still exists today.

No, that makes sense. Those were my only two questions. Congrats on the quarter.

Thanks, Rowland.

Thank you. We have another question from Pablo Singzon from JPMorgan. Your line is open.

Hi. Thank you. So my first question, it seems like the improvement in accident year loss fix, call it about one point from the first half last year to first half of this year, is low in light of a gap we're getting between price increases. To your point, I think you said like low double digits in loss trends, which I think in the past you've said it in the mid-single-digit range. Can you share your thoughts on that? And maybe, is there an element of conservatism in the loss picture setting? And I guess, would it be reasonable to assume something to drift down in those loss picks over time?

Yeah. Pablo, good morning, this is Mike. I would say, there's absolutely an element of conservatism in those loss picks. And I think they're highly likely to develop down over the years, as those losses come in and they're adjusted and settled out. And we're a relatively young company. It's our – I think our 12th accident year in business. But if you look back, every accident year but one of the very early ones has developed favorably on an inception-to-date basis. And so that's a really important goal for us as a management team. We want people to have a lot of confidence in our balance sheet. And so yeah, absolutely, conservative reserves, we're getting really good rate increases. And you match that up with a high-quality, very disciplined underwriting operation, and we expect the margin expansion to continue incrementally.

Got it. And along the same lines, could you speak about where you see the expense ratio trending? So obviously, passengers have been going down even as the company has been expanding, right? But just given the strong growth in premiums, that would likely persist for at least the next couple of years, how do you see that expense ratio trending?

We obviously are making investments in human capital and IT. As we grow, there's a possibility you'll see a little more drift down in that expense ratio. But I think, if you're looking over the long term, I think seeing where it is now, the 21% to 22% to 23% range over the long-term is probably where we would see it. But over the short term, you could see a slight improvement in that.

Yeah. Keep in mind that it's a lot of it is mix of business, as Brian said earlier on in his comments. We reinsure some lines of business where we get a ceding commission, which could help push that down if we saw an uptick in our excess casualty business, for instance. So that's one big component. I think the variable is mix of business and then headcount.

Got it. And then last question for me. Thanks for the update on capital, but can you remind us again what kind, or what levels being leveraged you'd be comfortable running at? And I suppose next year, your surplus could potentially be funded by debt and equity depending on how growth plays out. But I guess, just sort of big picture what kind of leverage Kinsale would be comfortable running at? Thanks.

Yeah. I think it's a 20% debt to total capital is kind of our long-term target. I think we're about 6% today. So we got a ways to go. But that's why we made the comments about really as we need additional capital to grow the business, we would look to debt not equity at this point.

Got it. And premium leverage – or actually, that was the question. I should have been clear. Premium leverage and I guess, depending on how you grow, right that will affect your premium leverage. But – and well to me affect, how much of that you might have to raise, but what premium leverage would Kinsale be comfortable running at? Thank you.

Yeah. The AM Best BCAR model, I mean it's a complex capital model. The big drivers within that are reserves and premium, but there's other charges for growth and investments, etc. And so there's no specific premium to surplus ratio that would be driven from the model. But we just guesstimate somewhere in the little bit higher than 1.2:1 net written premium to statutory surplus. That's not GAAP equity and GAAP equity and stat surplus are correlated but they're different numbers. So for what that's worth. Obviously, we're A-rated and AM Best is our – that's our AM Best rating. That's a really important number for us, and we're going to maintain that A rating. So, 1.2 to 1.25 to 1, I think is a good guess.

Okay.

Thank you.

Thank you, Pablo. We have another question from the line of Jamie Inglis from PhiloSmith. Your line is open.

Hi. Good morning. I'm interested in following up on your comments about inflation and how it benefits you when your rates or premiums are linked to revenue or payroll, as it allows you to benefit from inflation on the revenue side. But how does that work on the other side? If we pay a claim today, it relates to a policy that was written some time ago, which could be a while back depending on the type of policy. So, does today's inflation enable you to set aside more from a reserve perspective, or is it not that straightforward?

This is Mike. I would say that this is going to be a very complex topic, how inflation works its way through our book of business. Clearly, if we collect a premium today and settle a claim in three years, that claim is going to be inflated, which is a negative. The fact that we write a policy for $10,000 and at the end of the year, the contractor that we're insuring has charged higher rates because of inflation, we're going to collect and audit additional premium. That's an inflation benefit. And there's a lot of those that work their way through our business. But I would say in general, we'd like stable pricing. But given the inflation-sensitive pricing mechanism, it provides a little bit of protection. And then, I think Brian commented earlier that the conservatism in our reserve position provides additional protection. And then, I would also say the fact that we tend to focus on posting lower limit policies probably provides another round of protection, right? But there's a lot of different things with inflation that would probably go either for us or against us.

Okay. Great. Thanks for your help.

You bet.

Thank you, sir. There are no further questions at this time. I will now turn the call back to Mr. Michael Kehoe for closing remarks, sir.

Okay. Thank you, operator, and thank you everybody for joining us. We look forward to another positive call here in a few months. Have a good day.

Thank you, sir. Ladies and gentlemen, this concludes today's conference call. You may now disconnect. Thank you for participating. You have a good day.