Kinsale Capital Group, Inc. Q4 FY2022 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 2021 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 fourth quarter results. Kinsale's management may also reference certain non-GAAP financial measures in the call today. A reconciliation of GAAP of 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.

Thank you, operator, and good morning, everyone. Brian Haney, Kinsale's Chief Operating Officer, and Bryan Petrucelli, Chief Financial Officer, are both with me. Each of us will make a few comments, and then we'll move on to any questions that you may have for us. In the fourth quarter, Kinsale's operating earnings per share increased by 48%, and gross written premium grew by 45%. The company posted a 72.4% combined ratio for the quarter and an operating return on equity for all of 2022 of 25%. We believe these results are principally driven by Kinsale's unique business model of disciplined underwriting and technology-driven low costs. The results are also boosted by the favorable E&S market, which continues to experience a strong inflow of new business that allows for meaningful rate increases and exposure growth. Kinsale continues to raise rates above the loss cost trend, as we have been doing for four years now. And we continue to establish reserves for future losses in a conservative fashion. Investors should have a high level of confidence in Kinsale's balance sheet and reserve position. As an E&S company, part of Kinsale's long-term success is reacting quickly to market disruptions and turning those disruptions into opportunities. Over the last couple of years and continuing even today, Kinsale is taking advantage of the disruption in the property market to grow our book of business at a rapid rate. As always, we are mindful of the volatility associated with property accounts, especially hurricane-exposed properties in the Southeastern United States. Although we are writing more property business than ever, we maintain strict limits on the geographic concentration of business, we model the portfolio regularly, we manage our policy limits carefully, we purchased a substantial reinsurance program, and most importantly, we are being well paid for the risks we're taking. All of these steps allow us to write the business and capture an attractive return while continuing to limit the volatility of the book. In 2022, property amounted to just under 23% of our gross written premium, with below 10% of our overall gross written premium having any meaningful hurricane exposure. We announced in late December that Kinsale had acquired two office buildings and 29 acres of land for just over $76 million. This property is adjacent to our existing headquarters building. One of the office buildings is subject to a long-term lease. The other is mostly vacant, and we are planning to renovate that property. The purchase gives Kinsale expansion space next to our existing building and also provides an interesting investment opportunity, as we consider selling parts of that property to real estate developers over the next several years. Lastly, we continue to have an optimistic outlook for the market for the balance of 2023, at this point halfway through the first quarter. The property market is quite favorable, but we also see opportunities across our casualty product line as well. Regardless of where the market goes in the next couple of years and given Kinsale's competitive advantages, we expect the company to continue to grow and generate best-in-class returns under any market conditions. Now, I'll turn the call over to Bryan Petrucelli.

Thanks, Mike. Again, just a really strong quarter and close to the end of the year with a 45% growth in written premium, and net income and operating income increasing by 39% and 48%, respectively. A 72.4% combined ratio for the quarter includes 3.3 points from net favorable prior year loss reserve development compared to 4 points last year and a negligible impact from cat losses in either period. Most of the improvement in the quarterly expense ratio, so the 19.9% this quarter compared to 21.4% last year, related to ceding commissions from the company's casualty and commercial property proportional reinsurance agreements. Net investment income increased by 107% over the fourth quarter last year as a result of continued growth in the investment portfolio and higher interest rates, with a gross return of 3% for the year compared to 2.5% last year. We're investing new money in shorter-duration securities, with new money yields averaging close to 5% during the quarter and duration has decreased to 3.5 years, down from 4.3 years at the end of 2021. Book value was positively impacted in Q4 from a combination of net income, an increase in the fair value of our fixed-income securities during the quarter, and the $47.5 million equity raise in November. Notwithstanding the positive fourth quarter movements, our fixed income portfolio continues to be in an overall unrealized loss position, resulting from the higher interest rate environment. The company continues to generate strong positive operating cash flows, which gives us the ability to hold these securities to maturity and the higher interest rate environment allows us to invest new money at better yields that I just touched on. As it relates to capital, as I mentioned, we raised approximately $47 million in our fourth quarter equity offering to fund the expected growth of the company. We continuously monitor our needs as market conditions change. Given the continued favorable market conditions and related premium growth, there's always the possibility that we'll need additional supporting capital. Support can come in the form of debt or equity with a bias towards debt, given our current modest debt-to-capital position. Lastly, diluted earnings per share was $2.60 per share for the quarter compared to $1.76 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 fourth quarter, largely consistent with the first three quarters. Overall, the E&S market remains favorable, with strong growth across most of our product line. The property market continues to be hard, and in the wake of Hurricane Ian, the contraction in industry capacity has continued as we believed it would. In addition to our property divisions, we are seeing strong growth across most of our casualty divisions. Our energy, general casualty, and entertainment divisions in particular continue to grow at a significant pace. There are some pockets of business that are more competitive and flat or slower growing, such as management liability and product liability. Submission growth continues to be strong just under 20%, which represents a very slight deceleration from the previous quarter. We sell a wide array of products, and the rates in those products don't move in lockstep, but if we boil it all down to one number, we see real rates being up around 7% in the aggregate during the fourth quarter compared to 8% in the third quarter. The property market is certainly boosting that number. The rate changes for our property would be well higher than the average. The rate changes for the casualty divisions would vary greatly, but overall would be less than the average, but still positive, which indicates that the combination of rate change and the premium trend is exceeding loss cost trend. It is important to stress that rate change and rate adequacy are two different concepts. Our rates are more than adequate. We are continually reviewing and adjusting our rates based on a number of considerations, such as our target combined ratio, our target return on equity, the market opportunity and shifts in the competition. We continue to keep an eye on inflation. We feel we're in a good position because we've been achieving rate increases ahead of the loss cost trend for several years now, as Mike mentioned. These increases combined with our strategy of conservative reserving further protects us from the threat of inflation that some of our peers may be more exposed to. The market conditions are generally favorable across the board. We do still see a proliferation of MGAs and fronting deals. We don't delegate underwriting authority ourselves, but virtually all our competitors do in some fashion or another. Some of these MGAs are being overly aggressive on rates and terms, not all, but some. But despite these new MGAs and new fronting deals, the market has not been too affected at this point. Overall, clearly, a good quarter, and we are happy with the results. And with that, I'll hand it back over to Mike.

Thanks, Brian. Operator, we're ready for questions now.

Your first question comes from the line of Mike Zaremski from BMO. Your line is open.

Good morning, Mike.

Good morning, everyone, and happy Friday. It seems there's a growing sense of optimism regarding property growth. It appears you are allocating more to reinsurers as well, and if my understanding is correct, this suggests a careful approach to growth in property, especially in light of the increasing reinsurance costs. Could you provide an update on how we should view this growth and whether there are any anticipated changes to your reinsurance program this year?

Okay. Yes, this is Mike. So, we buy a lot of our reinsurance on our excess casualty book where we put up larger limits and on our property book. And so, yes, the growth in the property is going to result. I mean, that mix of business shift, both the growth in casualty and property, is going to result in a higher ceding ratio over time. The property is ceded on an earned premium basis. So, there's a little bit of a lag between when we write the business and when we earn it. But in general, it would be reasonable to expect an incremental increase in the ceding ratio here for the near term.

Should we consider the impact of IR reinsurance costs on how we evaluate any of the ratios for 2023, or will that be determined as the year progresses?

It's difficult to say at the moment. Our program renews on June 1st. There has been substantial discussion about rising reinsurance costs, and we anticipate that will be the case with our cat excess of loss treaty. However, this isn't a significant expense for our company, as we currently purchase $75 million in coverage over $25 million. On the proportional side, our largest contract is our commercial property quota share, which has shown favorable results. Therefore, we don't foresee any major changes in the economics when that treaty is renewed, and the same applies to the casualty side. Overall, we've ceded attractive returns to our reinsurers over the long term, which should be reflected in the renewal pricing. However, since it’s a June 1st treaty, it remains somewhat uncertain at this point.

Okay. Understood. We, obviously, know that you're more profitable than the industry, so maybe pricing for you guys is a bit better. Just thinking about your commentary about growth in the near term, I mean, is there enough line of sight into kind of new growth in the property side that we should be thinking about the gross premiums written growth rate kind of continuing near recent levels at least for the foreseeable future?

The things we look at, I would say, if you look at the last four years, we've been growing either just below or just above that 40% rate. I would say that's an extraordinary growth rate in our industry. It's driven in part by some pretty dramatic increases in pricing. And it's been driven in part by strong growth in exposure. I think Brian Haney commented that our flow of new business submissions continues around that 20% growth level. And we've always looked at that as a little bit of a leading indicator. And then, just some of the commentary again in the press and whatnot about distress in the reinsurance market. There's been a little bit of commentary lately about reinsurers' concern with adverse development across the industry for the '15 to '19 accident years on the casualty side. I think that would be a good omen in terms of forecasting decent growth prospects for the industry. The E&S tax receipt information from some of the big E&S states like California, Texas, Florida, and New York seemed to indicate that, at this point in the first quarter of 2023, the E&S market continues to grow, had a pretty dramatic rate. So, all those things I think give us a good sense of optimism for 2023, certainly. Beyond that, it gets a little bit more speculative.

Okay, great. Lastly, some industry participants have noticed a slight narrowing spread between pricing and estimated loss cost trend. I appreciate the commentary you provided on pricing earlier. Is there anything significant you've observed regarding loss trends, particularly any incremental increases in loss trends across various lines?

No, I think we noted a slight deceleration in the real rate, and the reason we mentioned the real rate is because there's the effect of a premium trend in there. So, we're seeing, generally, the same things our competitors are doing. We're just trying to convey it in a way that makes more sense and sort of ties more towards the movement in adequacy across the book.

And I think our estimate of loss cost trends pretty steady from the third quarter.

Yes, what we observe in the underlying data is quite similar to what our competitors report, indicating a slight deceleration or a reduction in the margin, as you mentioned, which reflects a narrowing of the gap.

Spread. Yes, got it.

Spread. That's the word, I'm sorry.

Okay. Thank you very much for the color.

Thanks, Mike.

Your next question comes from the line of Mark Hughes from Truist. Your line is open.

Good morning, Mark.

Yes, thank you. Good morning. So, when you're talking about real rates up 7%, you're defining that as nominal pricing less your judgment on inflation trends. Is that right?

Plus, also adjusted for the effective premium trend. Remember, a lot of our policies are sold on an inflation-sensitive exposure basis. So, as prices go up, the underlying premium goes up without even irrespective of the rate. So, for example, we cover products manufacturers. If the price of the product they are selling goes up because of overall inflation, that's going to give us more premium, with that resulting in more exposure necessarily. So, it's nominal rate change, adjusted for the loss cost trend and adjusted for the premium trend.

Okay. So, your spread essentially versus inflation would still be considered 7 points. Is that the right way to think about it?

If the real rate were zero, our rate adequacy should remain stable. If the real rate is positive, our rate adequacy is expected to strengthen.

And our real rate is 7%.

Our real rate is 7%.

Got you. Okay. And so, the nominal rate, presumably is something higher than that, add your inflation assumption on top of that would be your nominal rate. Is that right?

And the nominal rate going to be something in the high-single digits at this point. Loss cost trends also going to be in the higher single digits as well, and then we have new premium trends.

Bryan, what was your precise comment about submission growth of just under 20% compared to 20%, a little bit better than 20% previously?

I think it’s accurate to say that I mentioned just under 20% this quarter. Last quarter, I noted it was just slightly above 20%. It's quite modest. In fact, the number in the fourth quarter would be very similar to what we saw in the first quarter of 2022. There hasn't been much change.

Yes, okay. And then, Mike, you mentioned you don't buy that much XOL, cat XOL. What was the dollar amount of your payment last year for the cat XOL coverage?

We'll have to get back to you on that, I don't have that. I think it was $7 million or something like that is a guess. We'll get back to you on that.

My question was, how much did you pay for the reinsurance coverage, maybe not how much did you cede to the reinsurer?

It was somewhere in the mid-single digits, is what we paid for our cat XoL treaty for the current year as a deposit premium.

Yes, all right. So, if you get inflation on that, it's not a big deal to your point?

Correct.

And then, how much more appetite do you have, is there a kind of upper bound in the near to medium term when you think about where you're getting this growth and property and excess casualty? How much more are you comfortable taking on within your mix?

Well, I think you're always looking at the risk you take relative to your capital base and relative to the expected profitability. So, we've got a strong appetite to grow our business, especially when we were able to get rates like we get in the current pricing environment. Keep in mind, we've been raising rates ahead of trend for probably four years in a row now. So, this is an extraordinary opportunity to create wealth for our stockholders. And so, yes, we're working very hard to take advantage of it. The one added complication on the property side is that property, depending on the coverage you're selling can come with an extraordinary amount of volatility. And that's why I kind of belabor that point about, yes, property is growing for us at a rapid rate, but we're doing all sorts of things to make sure that's the volatility is not growing. We maintain a very broad geographic spread. So, a lot of our property business is really driven by fire apparel as opposed to hurricanes that you would get if you write coastal business in the Southeast United States and the like. So, we see it as a tremendous opportunity. We're working hard to take advantage of it, but we're also managing the volatility carefully.

Bryan, when we consider your growth in written premium, which is up 45% and consistent with previous periods, there may be some shifts towards property or excess casualty. This could influence your earnings, but the ceding commissions help lower your expense ratio. Is the earnings contribution from that written premium similar, slightly lower, or slightly higher when accounting for what you’ve retained and its effect on the P&L? I'm trying to understand the quality of the 45% growth in this mix compared to different mixes from earlier periods.

Mark, I'll address the first question. From my perspective, as a public company, our investors prefer stability in our results. To manage that stability, we purchase reinsurance, particularly for property risks. We face natural catastrophe exposure and specifically for excess casualty, where we are setting higher limits. This area has significant margins. Our reinsurers have achieved decent returns from covering our business over the years, and we benefit from the ceding commission as well. Essentially, we are transferring some volatility and replacing part of our investment income on reserves with that ceding commission. Overall, I view this arrangement positively. I don't see it as being less profitable than our primary business; there are factors beyond mere profitability to consider. Ultimately, it helps us manage volatility.

Perfect. Thank you.

Your next question comes from the line of Casey Alexander from Compass Point. Your line is open.

Yes, thank you. Good morning.

Good morning.

My first question is about the ceding commissions and their effect on the expense ratio. Is this something that will continue, or is it just a one-time effect for the quarter?

I believe it will depend on the mix of business. If we see continued growth in the areas where we purchase reinsurance that include related ceding commissions, there could be significant movement. However, generally speaking, it is advisable to focus on our expense ratio over the 12-month period rather than the volatility from quarter to quarter.

Okay. Thank you. Secondly, while you have been earning more yield from your investment portfolio, over the last couple of quarters, the duration has been gone down pretty rapidly, which tells me that you're really just still rolling short-term securities on that. Is there a strategy to eventually expand that duration and capture some of that yield for the longer term?

Yes, Casey, this is Mike. The yield curves are inverted, so we're getting a significantly higher return on the two-year duration compared to the four and five-year durations. We're taking advantage of that. We may shift our strategy at some point, but we're currently accepting the rollover risk of a shorter portfolio for the increased yield. Brian mentioned earlier that we're seeing around 5% returns on new investments, which is roughly double what we experienced a little over a year ago.

Yes. Lastly, what is the age of the buildings that you purchased?

I think one may have been built in the 1960s and one may be in the 1980s, around 1980. I kind of forget, exactly, but they're very well-maintained, and I don't think there's any real issue with the one that's subject to the long-term lease. The older of the two does need to be renovated, and our basis in that purchase is pretty modest. So, we feel pretty positive about the return prospects on that deal.

All right. Thank you for taking my questions.

Your next question comes from the line of Andrew Anderson from Jefferies. Your line is open.

Hey, good morning. It's really strong growth this quarter, so it doesn't appear to be coming in results, but I'll ask anyways. I think last quarter, you had mentioned some slowdown in construction-related business. Has the degree of that changed or expanded to any other lines? Maybe just more broadly just economic thoughts here?

Yes. We are still observing a slight slowdown compared to previous years. I want to emphasize that our construction unit encompasses both residential and commercial projects, including new construction and renovations across all segments. When examining total construction spending in the U.S., it is not actually declining; it is simply not growing at the pace seen in the previous year. Our observations align with the data from the Federal Reserve regarding total construction spending, which is likely growing around 6% or 7% nominally.

Got it. Thanks. And then, submission growth is still very strong here, ticked down just a bit. But perhaps with casualty becoming less of a difficult marketplace for brokers to place business, could that create some pressure on commission rates that you're paying to brokers since I think it's a bit below average right now?

This is Mike. I would say there is always pressure on commission. Our brokers are critical to our success. We worked very hard for them. We do pay slightly lower commissions than some of our competitors, but we also offer the marketplace and our brokers a much broader risk appetite. By not delegating underwriting authority, we're able to consider some tougher traditionally E&S placements. Where a lot of our competitors that delegated underwriting authority, especially on small accounts, tend to almost migrate to more of a preferred type risk. We also have a very-high service model. We quota an extraordinary percentage of the new business submissions we receive, and we quote them very quickly. So, I think that helps offset some of the commission issues. And finally, we're a low-cost provider. One of the extraordinary things about Kinsale's business model is, we're able to operate with an expense ratio that's really dramatically lower than the general marketplace, which gives us a lot of flexibility to offer more value to the business owner in the form of more competitively priced insurance, but at the same time, deliver best-in-class returns to our stockholders. So, for those reasons and a variety of others, yes, there's always pressure on commission, but we don't anticipate any changes there.

Thanks. So, maybe just like a market-related question. I think we heard from a larger peer that they think of a sandbox for small commercial E&S of around $8 billion. Is that roughly how you view it, or is it a bit more of a moving target?

No, we would say that would wildly understate the market. I haven't seen the 2022 statistics, but the biggest E&S writer in the United States is Lloyd's, which is obviously not a single entity, but it's a marketplace. And I think they were close to 17% market share in 2021. I think that puts some number of over $8 billion. And most of what I think they write in the United States is small commercial. They delegated underwriting authority to all of the wholesale brokers we work with. For most of those brokers, Lloyd's is one-off or maybe is their largest market. So, we would look at the total addressable market for E&S is somewhere between two-thirds and three-quarters. And we would estimate the market for 2022 was about $100 billion.

Great. Thank you.

Your next question comes from the line of Pablo Singzon from J.P. Morgan. Your line is open.

Hi, good morning. Mike, can you comment on the competitive environment you're seeing in the market? So, other E&S companies have been growing fast as well, some of them the largest, right? And I think at this point, the broader E&S industry has recognized the attractive opportunities in E&S. So, just sort of your thoughts on the latest on where you see the competition these days.

Yes, as Brian Haney mentioned, we are optimistic about the market environment. It differs by product line, but overall, it is generally more favorable for sellers compared to typical competitive periods in the insurance cycle. However, we only secure about 10% of our new business quotes, which aligns with our performance over the last four years. This underscores the intense competition, with numerous new entrants and several fronting companies having emerged recently to connect managing general agents to reinsurance capacity. There are many delegated underwriting authorities available. Additionally, there is a significant shift of business from the standard to the non-standard market, where we are competing with around 75 other risk-bearing entities, along with a large number of managing general agents. Overall, I view it as a balanced market. The property sector is somewhat of an exception due to recent catastrophic losses and reduced reinsurance capacity, making that a challenging market. However, for our casualty lines, we are optimistic with positive rate changes, strong top-line growth, and impressive profitability, even amidst inflation. This encapsulates our perspective on the current market.

Got it. I have a couple more questions about underwriting. Given your comment on the spread between pricing and loss trends, would it be reasonable to expect some level of continuous improvement in your loss ratio next year, but perhaps not as much as in previous years? Is that a fair way to think about it?

I would say, just given the level of inflation, the court systems are reopening from COVID. There's still a lot of uncertainty out there. And so, I think that always causes us to be cautious in terms of establishing reserves for future claims and just being very conservative in that regard. You saw our favorable development dropped by a point or so. Again, you're just seeing some of the conservative approach to building the balance sheet. So, I don't think we're really forecasting where that loss ratio to go. You have to balance, I think, the prices we charge with expectations for inflation and loss development.

Okay. Regarding the comments on cost control in the press release, while you may not operate the business this way, is there an effort to ensure that revenue growth consistently exceeds expense growth? How are you approaching that aspect of the business? I ask because you did mention it in the commentary in the press release.

Well, Pablo, if you examine our cost breakdown, we have an average expense ratio of about 20%. Approximately 12% of that is related to commissions, while the remaining 8% pertains to other operating expenses. The majority of that 8% is associated with human capital costs. As we monitor the business's progression, we are hiring to support that growth. If the market changes and growth slows down, we believe we are in a strong position to respond quickly.

Yes. I would just add that, that expense advantage I think is a fundamental part of our business strategy. And so, it's something we're always working on not just maintaining but looking for ways to improve on it, principally by driving more automation into our business process. That's a slow, steady process that involves rolling out new technology, but that's definitely an ongoing goal.

Okay. I have one last question. You mentioned growth and your expectations regarding capital. My follow-up is, could you give an idea of the benchmarks you're considering for balancing capital needs with growth? Given that you have access to various capital resources, your earnings could support significant growth, particularly if you maintain a 20% return on equity. However, there might be a point, whether in percentage growth or total dollars, where you would need to seek additional capital. Any broad, high-level insights that could help us understand your capital requirements in relation to growth would be appreciated. Thank you.

Yes. So, our retained earnings are a phenomenon. If you look at the returns we're generating, that finances a lot of our growth. I think Bryan indicated that we would look to borrow some additional money, should we need external capital. And then, hey, if the growth is so extraordinary that we need additional equity capital, you're liable to see something like we've done in the last several years, very small equity capital raises at attractive prices that really don't impact the existing shareholders much at all.

Got it. Thank you for your answers.

Okay.

Your next question comes from the line of Rowland Mayor from RBC Capital Markets. Your line is open.

Hi, good morning. Regarding the debt discussion, I believe the debt-to-cap ratio has increased to 21% this quarter. While a high return on equity can address this issue over time, if you are considering another debt offering, is there a point at which you would avoid raising the debt-to-cap ratio beyond that in the short term? Additionally, where do you anticipate that debt-to-cap ratio will level off in the long term?

This is Mike. I mean, we like that 20% or so range as a long-term and conservative level of debt on our balance sheet. The ratio has been boosted lately with the real estate purchase. But there's going to be some real estate sales over time, that will bring that backdown. But in terms of the insurance business in particular, we like the 20%, and we like the idea of using debt versus equity if we can and maintain a good conservative balance sheet.

Okay. Thank you. And then, I guess, this is another way to come at the growth question. How does your headcount scale relative to your premium growth? And is there a point where it becomes growing 40% on 40% on 40% becomes an issue of not being able to hire enough talent? Or can you just walk through sort of the organizational management of that growth?

Yes. As we continue to grow the business rapidly, we are definitely adding to our underwriting and claims teams. Over the past couple of years, we have also significantly increased our investment in our IT department to enhance automation in our business processes. We've seen remarkable productivity growth recently. For example, our headcount at the end of 2021 was 367 employees, and by the end of 2022, it rose to 457. Clearly, we have hired extensively. Our approach varies by department; in underwriting, we are welcoming many newcomers to the industry and training them. In claims and IT, we have a blend of both new and experienced professionals. Kinsale has invested considerable effort over the years in developing our workforce and human capital, and this has been beneficial in supporting our growth without staffing shortages limiting our expansion.

Very helpful. Thank you so much.

And there are no further questions at this time. Mr. Mike Kehoe, I turn the call back over to you for some final closing remarks.

Okay. Thank you, operator. And thank you for everybody for participating. Obviously, the results we posted for 2022 are the result of a lot of extraordinary hard work by that Kinsale professionals who come to work here every day. So, we definitely want to recognize everybody on Kinsale team and all the Kinsale brokers around the country that are critical part of our success, and obviously, we continue to work very hard for them to help them build their businesses. And we look forward to talking to everybody again in a few months.

This concludes today's conference call. Thank you for your participation. You may now disconnect.