Kinsale Capital: Strong Profitability, But Overvalued (NASDAQ:KNSL)

Kinsale Capital Group (NASDAQ:KNSL) has a superb management team that runs the company exceptionally well, with great profitability.

Kinsale operates in the property & casualty industry, focusing on the pure-play E&S insurance for small businesses. Kinsale, since going public, has done a wonderful job growing the business while posting strong premium growth.

The company has created strong profitability and revenue growth over the last three years, but it is priced like it’s a tech company, with outsized price metrics corresponding with someone like AMD (NASDAQ:AMD) or Tesla (NASDAQ:TSLA).

Let’s dive in and look under the hood of Kinsale and see what is happening with the company.

Overview

Kinsale Capital Group recently released its second-quarter 2020 results. Let’s take a look at those results first, and then we can discuss other ideas such as growth, risk, and valuation of Kinsale.

Kinsale, based out of Richmond, VA, currently has a market cap of $4.4 billion and a current market price of $202.60 as of the writing of this article.

The company operates in the property and casualty industry and specializes in the U.S. excess and surplus market, focusing in particular on small businesses. Kinsale reports on one single segment, the Excess and Surplus Lines Insurance segment, and the breakdown for the first six months of 2020 of gross written premiums was 87 percent casualty and 13 percent property.

As for Covid-19 impacts, the company reports through the first six months negligible impacts on the business. The company does not write claims with heightened exposure to Covid-19 at this time.

Some financial highlights from the quarter (all comparisons will be in relation to the second quarter of 2019):

  • Gross written premiums of $134.0 million, which was a 41.2 percent increase.
  • Net written premiums of $117.6 million, which was a 42.2 percent increase.
  • Underwriting income of $15.6 million, an increase of 55.8 percent.
  • Net operating earnings of $19.1 million, an increase of 53.7 percent.
  • Combined ratio of 83.8 percent.
  • Annualized return on equity of 28.2 percent.

Net income for Kinsale was $30.3 million for the quarter, an increase of 119.8 percent, which the company reported as due to higher underwriting income from favorable E&S market conditions, strong growth from the broker commissions, and the higher unrealized gains from the rebound in the equity investment portfolio.

Premiums

Kinsale reported that underwriting income rose as a result of premium growth quarter over quarter and increasingly favorable developments on loss reserves as accident levels dropped with the decreased activity over the past six months.

As stated above, the gross written premiums improved substantially; Kinsale reported that market conditions were favorable, which led to increased submission activity from brokers and higher rates on the bound accounts. The average premiums written rose from $7,600 to $8,500 in the quarter.

Net written premiums increased 42.2 percent for the quarter as a result of higher gross written premiums and a higher retention rate on those higher premiums. Kinsale reported an 87.7 percent retention rate for the quarter compared to 87.1 percent in the year-ago quarter.

Finally, net earned premiums improved by 46.7 percent for the quarter, as a result of higher written gross premiums.

Loss Ratio

Kinsale reported a loss ratio for the quarter of 60.1 percent, higher than the ratio reported in the second quarter of 2019 of 59.9 percent. The higher ratio was a result of higher loss selections for the current accident year, with improvements in the loss reserves from the prior year because of losses being reported at lower levels than expected from the prior year.

Expense Ratio

The company reported the expense ratio of 23.7 percent for the quarter compared to 24.9 percent from the second quarter of 2019. Kinsale stated the decrease was due to higher net earned premiums without expenses increasing proportionally as management focused on controlling those costs.

Investment Results

Kinsale’s net investment income increased by 38.3 percent for a total of $6.6 million compared to $4.8 million from the second quarter of 2019. The company stated the increases were a result of the growth of the investment portfolio balance from excess funds available for the growth of the portfolio, and the monies raised from the equity offering in the third quarter of 2019.

The investment portfolio had an annualized gross investment return of 3.0 percent for the second quarter, down from 3.2 percent in the second quarter of 2019.

Unrealized gains skyrocketed as the ETF securities portfolio rebounded nicely from the volatility of the first quarter of 2020, as the fair values of the securities rebounded sharply from the significant declines in the market in March as a result of the Covid-19 pandemic.

Kinsale also reported an annualized return on equity of 16.4 percent for the first six months of 2020, down from 22.7 percent from the first six months of 2019.

Some other metrics indicating the performance of Kinsale in the second quarter of 2020:

  • ROA TTM – 6.04%
  • Debt to Equity – 0.07
  • Net Margin % – 17.05%
  • Book Value Per Share – 20.45
  • Piotroski Score – 7

And finally, there is the dividend. Kinsale pays a dividend albeit a small one at $0.36 per share annually, with a yield of 0.18 percent. The dividend is safe with a payout ratio of 11.18 percent, but because of the short length of history, there are three years of dividend growth.

Let’s move on to talk about the growth story of Kinsale next.

Growth Story

The growth story of Kinsale must start with the revenue growth, of which the company has excelled since its IPO. According to Seeking Alpha’s rating system, Kinsale grades an A+ for its 41.02 percent year-over-year growth, along with the five-year growth rate of 33.8 percent. All of which are far above the sector median of 1.27 percent year-over-year growth, and 21.35 percent above the five-year average of growth.

The TTM net income of the company also grew at 35.4 percent year over year. Operating cash flow growth was 91.95 percent on a year-over-year basis.

All that revenue growth leads to profitability, which is evidenced by the combined ratio we discussed above.

As we can see from the chart below, the company has consistently done a fantastic job of creating profits from its underwriting by controlling the costs and underwriting discipline.

Keep in mind any combined ratio under 100 is considered profitable and what all property and casualty companies strive to achieve.

Along with the fantastic combined ratio, that leads Kinsale to the creation of insurance “float,” as evidenced by the chart below. As Buffett likes to say in his annual letters, the float is money Kinsale doesn’t own but holds, and the gap between collecting premiums and paying out losses allows the company to use those funds to invest in creating more income.

As we can see from above, Kinsale is doing a fantastic job creating a growing float that costs it nothing, which helps in the investment portfolio, even when there is extreme volatility.

Speaking of the investment portfolio, the total investments of Kinsale grew over $193.4 million over the previous year to a total of $1,001.2 million, including both fixed income securities and equity securities, which mostly comprise of ETFs.

Net investment income grew by 38 percent for the quarter to $6.645 million, along with the change in the fair value of equity securities of $13.839 million. Finally, $253 thousand in net realized gains.

All of which totals $20.737 million in income for Kinsale. Now the equity securities are going to be a continual roller-coaster because of the newish accounting rule governing the addition of realized/unrealized gains of securities on the income statement.

But the gains in the fixed income portion of the portfolio are real and are likely to continue into the future, combine that with the free money from the “float,” that is just extra cash in Kinsale’s pocket for doing a great job on the underwriting front.

Finally, another key growth driver for Kinsale is its proprietary technology platform. Kinsale utilizes an integrated platform that is an end-to-end system that handles the whole process of writing premiums, from submissions, underwriting, claims, and billing.

The use of this platform is a key advantage for Kinsale, as it allows the company to react to submissions in hours instead of days. Kinsale’s response time is a major advantage, plus the company’s focus on writing tighter coverages. Because Kinsale works with smaller customers instead of trying to broaden coverages, constraining itself to tighter coverages leads to better values for the customers and higher retention rates for Kinsale.

Another advantage Kinsale enjoys is the experienced executives that run the company, many of whom used to work for James River, a major competitor. That experience translates to Kinsale having the ability to scale up quickly.

Risks

Among the many risks that Kinsale faces are best described by the fantastic article written by Eric Jensen:

Kinsale Beat Earnings Expectations, But I Retain My Short

He highlights the risks that Kinsale faces now and into the future far better than I ever could.

And I agree with his contention that the company faces higher risks from the Covid-19 situation as the economy continues to flounder. Until a vaccine is found, the economy will struggle as we struggle to contain the virus.

The other issue I see is the extreme overvaluation of the company, which I will discuss in the next section. Kinsale is priced with the metrics of a tech company; those growth rates are just not sustainable for a property & casualty company and will come back to earth. As Eric mentions, the company may be able to grow and take market share for a while, but eventually, those opportunities will slow down.

Valuation

Let’s move on to my favorite part of analyzing a company, the valuation.

Starting with Seeking Alpha authors, who rate the company as bearish, and Wall Street is bearish on the company. The company has a Quant rating of 3.44, which is neutral, and the company is ranked 8th out of 43 in the property and casualty industry.

Next, looking at the company on a relative basis. Seeking Alpha gives Kinsale an F grade for value on its rating scale. We see that Kinsale has a GAAP TTM P/E of 66.44, which compared to the sector P/E of 11.68 is a great indication of overvaluation. As the company is newer to the public sector, we don’t have a five-year average to compare.

The company went public in 2016, and the P/E has ranged from a low of 27.22 to the current level, so it would appear the company has been highly-priced from the get-go.

Comparing the P/B for Kinsale to the sector median also gives us an indication of its overvaluation with a current TTM of 9.53.

In fact, if we look at any of the relative basis metrics, the company is looking overvalued. Frankly, I have never seen an insurance company with relative metrics such as Kinsale’s. It is almost like it is a tech company such as AMD or Tesla with these valuations.

Ok, let’s look at the company from an intrinsic valuation basis using an excess returns model. I will include my assumptions along with the chart so you can follow along at home.

As we can see from the model, Kinsale is overvalued on an intrinsic value basis.

Based on a relative and intrinsic value basis, I think Kinsale is overvalued. Mr. or Mrs. Market is pricing in all the growth, profitability, and potential of the company into the price, leaving no margin for safety on any calculations.

Final Thoughts

When I first stumbled upon Kinsale, I saw all the great growth metrics and profitability, which jump off the page, but I also saw signs the company had all that profitability priced in abundance.

After exploring several annual reports and several quarterly reports, plus the last two earnings call transcripts, I can say Kinsale has a superb management team that runs the company exceptionally. It has also created a great system, which allows it to capitalize on the market.

Kinsale, with great management, is extremely profitable and does a great job of disciplined underwriting, as evidenced by the fantastic combined ratios through the years.

The big sticking point is the price; the company is simply too expensive for the earnings it creates.

At this time, I am going to pass on the company, but I will put it on my watch list to keep an eye in the event that the price comes back to earth.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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