Kinsale Capital Group, Inc. 10-K

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the accompanying notes included elsewhere in this Annual Report. The discussion and analysis below include certain forward-looking statements that are subject to risks, uncertainties and other factors described in "Risk Factors" that could cause actual results to differ materially from those expressed in, or implied by, those forward-looking statements. See "Forward-Looking Statements." Year ended December 31, 2019 compared to year ended December 31, 2018 For a comparison of years ended December 31, 2019 and December 2018, see “Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our annual report on Form 10-K for the fiscal year ended December 31, 2019, which was filed with the SEC on March 2, 2020. Overview Founded in 2009, we are an established and growing specialty insurance company. We focus exclusively on the E&S market in the U.S., where we use our underwriting expertise to write coverages for hard-to-place small business risks and personal lines risks. We market and sell these insurance products in all 50 states, the District of Columbia, the Commonwealth of Puerto Rico and the U.S. Virgin Islands primarily through a network of independent insurance brokers. We have an experienced and cohesive management team, that has an average of over 25 years of relevant experience. Many of our employees and members of our management team have also worked together for decades at other E&S insurance companies. We have one reportable segment, our Excess and Surplus Lines Insurance segment, which offers P&C insurance products through the E&S market. In 2020, the percentage breakdown of our gross written premiums was 85.6% casualty and 14.4% property. Our commercial lines offerings include construction, small business, excess casualty, commercial property, product liability, allied health, life sciences, general casualty, professional liability, management liability, energy, environmental, health care, inland marine, public entity and commercial insurance. We also write a small amount of homeowners insurance in the personal lines market, which in aggregate represented 3.9% of our gross written premiums in 2020. Our goal is to deliver long-term value for our stockholders by growing our business and generating attractive returns. We seek to accomplish this by generating consistent and attractive underwriting profits while managing our capital prudently. We believe that we have built a company that is entrepreneurial and highly efficient, using our proprietary technology platform and leveraging the expertise of our highly experienced employees in our daily operations. We believe our systems and technology are at the digital forefront of the insurance industry, allowing us to quickly collect and analyze data, thereby improving our ability to manage our business and reducing response times for our customers. We believe that we have differentiated ourselves from our competitors by effectively leveraging technology, vigilantly controlling expenses and maintaining control over our underwriting and claims management. COVID-19 We are closely monitoring the impact of the COVID-19 pandemic and related economic effects on all aspects of our business, including how it will impact premium volume, losses and the fair value of our investment portfolio. To date, management has not seen a significant decrease in the growth rate of its gross written premiums since the beginning of the COVID-19 pandemic and related economic downturn. Over the past year, including a time period 40 Table of Contents preceding COVID-19, the E&S segment of the P&C market has been experiencing rapid growth due to dislocation in the overall property and casualty market. With respect to reported claims, Kinsale does not write lines of business with heightened exposure to COVID-19 related claims. Specifically, Kinsale does not write event cancellation, mortgage insurance, trade credit or surety, workers compensation or reinsurance business. Lines of business written by Kinsale that could be subject to COVID-19 related claims include general liability, management liability, healthcare-related professional liability and commercial property. In each case, policy terms and conditions would be expected to preclude coverage for virus-related claims. Although management cannot definitively determine the ultimate impact of COVID-19 and related economic conditions at this time, management does not currently expect a material adverse effect on Kinsale’s loss ratios due to COVID-19 related claims. With respect to our investment portfolio, we seek to hold a high-quality, diversified portfolio of investments. During the first quarter of 2020, we experienced a significant decline in the fair value of our investment portfolio due to disruption in the global financial markets associated with COVID-19. Subsequent to the first quarter of 2020, the fair values of our investment portfolio rebounded sharply, gaining back all of the decline in fair value. However, during economic downturns, certain investments may default or become impaired due to deterioration in the financial condition or due to deterioration in the financial condition of an insurer that guarantees an issuer’s payments on such investments. Given the conservative nature of our investment portfolio, we do not expect a material adverse impact on the value of our investment portfolio or a long-term negative impact on our financial condition, results of operations or cash flows as it relates to COVID-19. Components of Our Results of Operations Gross written premiums Gross written premiums are the amounts received or to be received for insurance policies written or assumed by us during a specific period of time without reduction for policy acquisition costs, reinsurance costs or other deductions. The volume of our gross written premiums in any given period is generally influenced by: • New business submissions; • Binding of new business submissions into policies; • Renewals of existing policies; and • Average size and premium rate of bound policies. We earn insurance premiums on a pro rata basis over the term of the policy. Our insurance policies generally have a term of one year. Net earned premiums represent the earned portion of our gross written premiums, less that portion of our gross written premiums that is ceded to third-party reinsurers under our reinsurance agreements. Ceded written premiums Ceded written premiums are the amount of gross written premiums ceded to reinsurers. We enter into reinsurance contracts to limit our exposure to potential large losses as well as to provide additional capacity for growth. Ceded written premiums are earned over the reinsurance contract period in proportion to the period of risk covered. The volume of our ceded written premiums is impacted by the level of our gross written premiums and any decision we make to increase or decrease retention levels. Losses and loss adjustment expenses Losses and loss adjustment expenses are a function of the amount and type of insurance contracts we write and the loss experience associated with the underlying coverage. In general, our losses and loss adjustment expenses are affected by: 41 Table of Contents • Frequency of claims associated with the particular types of insurance contracts that we write; • Trends in the average size of losses incurred on a particular type of business; • Mix of business written by us; • Changes in the legal or regulatory environment related to the business we write; • Trends in legal defense costs; • Wage inflation; and • Inflation in medical costs. Losses and loss adjustment expenses are based on an actuarial analysis of the estimated losses, including losses incurred during the period and changes in estimates from prior periods. Losses and loss adjustment expenses may be paid out over a period of years. Underwriting, acquisition and insurance expenses Underwriting, acquisition and insurance expenses include policy acquisition costs and other underwriting expenses. Policy acquisition costs are principally comprised of the commissions we pay our brokers, net of ceding commissions we receive on business ceded under certain reinsurance contracts. Policy acquisition costs that are directly related to the successful acquisition of those policies are deferred. The amortization of such policy acquisition costs is charged to expense in proportion to premium earned over the policy life. Other underwriting expenses represent the general and administrative expenses of our insurance business including but not limited to employment costs, telecommunication and technology costs, and legal and auditing fees. Net investment income Net investment income is an important component of our results of operations. We earn investment income on our portfolio of cash and invested assets. Our cash and invested assets are primarily comprised of fixed-maturity securities, and may also include cash and cash equivalents, equity securities and short-term investments. The principal factors that influence net investment income are the size of our investment portfolio and the yield on that portfolio. As measured by amortized cost (which excludes changes in fair value, such as changes in interest rates), the size of our investment portfolio is mainly a function of our invested equity capital along with premiums we receive from our insureds less payments on policyholder claims. Change in fair value of equity securities Change in fair value of equity securities represents the increase or decrease in the market value of equity securities held during the period. Net realized investment gains (losses) on investments Net realized gains (losses) on investments are a function of the difference between the amount received by us on the sale of a security and the security's amortized cost, as well as any allowances for credit losses recognized in earnings, if any. Income tax expense Currently all of our income tax expense relates to federal income taxes. Kinsale Insurance is generally not subject to income taxes in the states in which it operates; however, our non-insurance subsidiaries are subject to state income taxes. The amount of income tax expense or benefit recorded in future periods will depend on the jurisdictions in which we operate and the tax laws and regulations in effect. 42 Table of Contents Key metrics We discuss certain key metrics, described below, which provide useful information about our business and the operational factors underlying our financial performance. Underwriting income is a non-GAAP financial measure. We define underwriting income as net income, excluding net investment income, net change in the fair value of equity securities, net realized gains and losses on investments, other income, other expenses and income tax expense. See "—Reconciliation of Non-GAAP Financial Measures" for a reconciliation of net income in accordance with GAAP to underwriting income. Net operating earnings is a non-GAAP financial measure. We define net operating earnings as net income excluding the net change in the fair value of equity securities, after taxes, and net realized gains and losses on investments, after taxes. See "—Reconciliation of non-GAAP financial measures" for a reconciliation of net income in accordance with GAAP to net operating earnings. Loss ratio , expressed as a percentage, is the ratio of losses and loss adjustment expenses to net earned premiums, net of the effects of reinsurance. Expense ratio, expressed as a percentage, is the ratio of underwriting, acquisition and insurance expenses to net earned premiums. Combined ratio is the sum of the loss ratio and the expense ratio. A combined ratio under 100% generally indicates an underwriting profit. A combined ratio over 100% generally indicates an underwriting loss. Return on equity is net income as a percentage of average beginning and ending total stockholders’ equity during the period. Operating return on equity is a non-GAAP financial measure. We define operating return on equity as net operating earnings expressed as a percentage of average beginning and ending stockholders’ equity during the period. See "—Reconciliation of Non-GAAP Financial Measures" for a reconciliation of net income in accordance with GAAP to net operating earnings. Net retention ratio is the ratio of net written premiums to gross written premiums. Gross investment return is investment income from fixed-maturity and equity securities, before any deductions for fees and expenses, expressed as a percentage of average beginning and ending balances of those investments during the period. 43 Table of Contents Results of Operations Year ended December 31, 2020 compared to year ended December 31, 2019 The following table summarizes our results of operations for the years ended December 31, 2020 and 2019: Year Ended December 31, ($ in thousands) 2020 2019 Change Percent Gross written premiums $ 552,814 $ 389,694 $ 163,120 41.9 % Ceded written premiums (74,595) (47,633) (26,962) 56.6 % Net written premiums $ 478,219 $ 342,061 $ 136,158 39.8 % Net earned premiums $ 412,754 $ 282,981 $ 129,773 45.9 % Losses and loss adjustment expenses 263,802 169,563 94,239 55.6 % Underwriting, acquisition and insurance expenses 94,296 70,217 24,079 34.3 % Underwriting income (1) 54,656 43,201 11,455 26.5 % Other expenses, net (741) (31) (710) NM Net investment income 26,110 20,133 5,977 29.7 % Change in fair value of equity securities 16,855 12,389 4,466 NM Net realized gains on investments 3,533 359 3,174 NM Income before taxes 100,413 76,051 24,362 32.0 % Income tax expense 11,994 12,735 (741) (5.8) % Net income $ 88,419 $ 63,316 $ 25,103 39.6 % Net operating earnings (2) $ 72,313 $ 53,245 $ 19,068 35.8 % Loss ratio 63.9 % 59.9 % Expense ratio 22.8 % 24.8 % Combined ratio 86.7 % 84.7 % Return on equity 18.0 % 18.9 % Operating return on equity (2) 14.7 % 15.9 % NM - Percentage change is not meaningful (1) Underwriting income is a non-GAAP financial measure. See "—Reconciliation of Non-GAAP Financial Measures" for a reconciliation of net income in accordance with GAAP to underwriting income. (2) Net operating earnings and operating return on equity are non-GAAP financial measures. Net operating earnings is defined as net income excluding the effects of the net change in the fair value of equity securities, after taxes, and net realized gains and losses on investments, after taxes. Operating return on equity is defined as net operating earnings expressed as a percentage of average beginning and ending stockholders’ equity during the period. See "—Reconciliation of non-GAAP financial measures" for a reconciliation of net income in accordance with GAAP to net operating earnings. Net income was $88.4 million for the year ended December 31, 2020 compared to $63.3 million for the year ended December 31, 2019, an increase of $25.1 million, or 39.6%. The increase in net income in 2020 over 2019 was primarily due to higher earned premiums, resulting from favorable E&S market conditions and strong growth in 44 Table of Contents broker submissions, and higher returns on our investment portfolio. In addition, the increase in net income was also attributable to a lower effective tax rate generated from the tax benefits related to stock-based compensation activity and higher favorable development of loss reserves from prior accident years. These increases were offset in part by higher catastrophe losses incurred in 2020 compared to the prior year. Our underwriting income was $54.7 million for the year ended December 31, 2020 compared to $43.2 million for the year ended December 31, 2019, an increase of $11.5 million, or 26.5%. The increase in our underwriting income was attributable to a combination of growth in the business and higher net favorable development of loss reserves for prior accident years, offset in part by higher catastrophe losses incurred during the year. The corresponding combined ratios were 86.7% for the year ended December 31, 2020 compared to 84.7% for the year ended December 31, 2019. Premiums Gross written premiums were $552.8 million for the year ended December 31, 2020 compared to $389.7 million for the year ended December 31, 2019, an increase of $163.1 million, or 41.9%. The increase in gross written premiums for the for the year ended December 31, 2020 over the prior year was due to higher submission activity from brokers across most lines of business and higher rates on bound accounts, resulting from continued favorable market conditions. The average premium per policy written by us was $9,100 in 2020 compared to $8,200 in 2019. Excluding our personal lines insurance, which has relatively low premiums per policy written, the average premium per policy written was approximately $11,800 in 2020 compared to $10,800 in 2019. The increase in the average premium per policy written was due to changes in the mix of business and higher rates on bound accounts during 2020 compared to the prior year. The changes in gross written premiums were most notable in the following lines of business: • Excess casualty, which represented approximately 13.9% of our gross written premiums in 2020, increased by $25.5 million, or 49.8%, for the year ended December 31, 2020 over the prior year; • Commercial property, which represented approximately 9.4% of our gross written premiums in 2020, increased by $22.7 million, or 77.9%, for the year ended December 31, 2020 over the prior year; • Small business, which represented approximately 15.1% of our gross written premiums in 2020, increased by $20.1 million, or 31.8%, for the year ended December 31, 2020 over the prior year, and • Construction, which represented approximately 15.8% of our gross written premiums in 2020, increased by $16.2 million, or 22.8%, for the year ended December 31, 2020 over the prior year. Net written premiums increased by $136.2 million, or 39.8%, to $478.2 million for the year ended December 31, 2020 from $342.1 million for the year ended December 31, 2019. The increase in net written premiums was largely due to higher gross written premiums for the year ended December 31, 2020. Our net retention ratio was 86.5% for the year ended December 31, 2020 compared to 87.8% for the year ended December 31, 2019. The decrease in the net retention ratio was primarily due to change in the mix of business. Net earned premiums were $412.8 million for the year ended December 31, 2020 compared to $283.0 million for the year ended December 31, 2019, an increase of $129.8 million, or 45.9%. As previously discussed, the increase was due to growth in gross written premiums in 2020 compared to 2019. Loss ratio Our loss ratio was 63.9% for the year ended December 31, 2020 compared to 59.9% for the year ended December 31, 2019. The increase in the loss ratio for the year ended December 31, 2020 was primarily due to higher 45 Table of Contents catastrophe losses incurred in 2020 compared to 2019. Catastrophe losses incurred during the current accident year in 2020 were largely related to Hurricanes Laura, Sally and Zeta and the California wildfires. For each year of 2020 and 2019, the overall favorable development of loss reserves for prior accident years was primarily due to reported losses emerging at lower levels than expected for certain accident years. During the year ended December 31, 2020, prior accident years developed favorably by $13.3 million, of which $12.3 million was attributable to accident years 2019 and 2018. During the year ended December 31, 2019, loss reserves for prior accident years developed favorably by $9.4 million, which was largely attributable to accident years 2018 and 2017 of $14.6 million. This favorable development was offset in part by adverse development in the accident years 2011 through 2015 of $5.2 million, which resulted from higher IBNR reserves to provide for emergence of reported losses over a longer period of time based on observed trends. On an inception-to-date basis as of December 31, 2020, all accident years have developed favorably, with the exception of the 2011 accident year. The following tables summarize the effect of the factors indicated above on the loss ratios for the years ended December 31, 2020 and 2019: Year Ended December 31, 2020 2019 ($ in thousands) Losses and Loss Adjustment Expenses % of Earned Premiums Losses and Loss Adjustment Expenses % of Earned Premiums Loss ratio: Current accident year $ 253,948 61.5 % $ 175,939 62.1 % Current accident year - catastrophe losses 23,192 5.6 % 3,047 1.1 % Effect of prior year development (13,338) (3.2) % (9,423) (3.3) % Total $ 263,802 63.9 % $ 169,563 59.9 % Expense ratio The following table summarizes the components of the expense ratio for the years ended December 31, 2020 and 2019: Year Ended December 31, 2020 2019 ($ in thousands) Underwriting Expenses % of Earned Premiums Underwriting Expenses % of Earned Premiums Commissions incurred: Direct $ 69,922 16.9 % $ 48,382 17.1 % Ceding (16,145) (3.9) % (12,347) (4.4) % Net commissions incurred 53,777 13.0 % 36,035 12.7 % Other underwriting expenses 40,519 9.8 % 34,182 12.1 % Underwriting, acquisition, and insurance expenses $ 94,296 22.8 % $ 70,217 24.8 % 46 Table of Contents The expense ratio was 22.8% for the year ended December 31, 2020 compared to 24.8% for the year ended December 31, 2019. The decrease in the expense ratio was primarily due to higher net earned premiums, without a proportional increase in the amount of other underwriting expenses as a result of management's focus on controlling costs. Direct commissions paid as a percent of gross written premiums was 14.6% for the years ended December 31, 2020 and 2019. Investing results Our net investment income increased by 29.7% to $26.1 million for the year ended December 31, 2020 from $20.1 million for the year ended December 31, 2019, primarily due to growth in our investment portfolio balance generated from excess operating funds and to a lesser degree, proceeds from our equity offerings. The following table summarizes the components of net investment income and net investment gains for the years ended December 31, 2020 and 2019: Year Ended December 31, ($ in thousands) 2020 2019 Change Interest from fixed-maturity securities $ 24,111 $ 18,545 $ 5,566 Dividends on equity securities 3,512 2,136 1,376 Other 262 842 (580) Gross investment income 27,885 21,523 6,362 Investment expenses (1,775) (1,390) (385) Net investment income 26,110 20,133 5,977 Change in the fair value of equity securities 16,855 12,389 4,466 Net capital gains 3,533 359 3,174 Net investment gains 20,388 12,748 7,640 Total $ 46,498 $ 32,881 $ 13,617 The weighted average duration of our fixed-maturity portfolio, including cash equivalents, was 4.3 years at December 31, 2020 and 2019. Our investment portfolio had a gross return of 2.9% as of December 31, 2020, compared to 3.1% as of December 31, 2019. During the year ended December 31, 2020, we recognized unrealized gains related to our equity portfolio of $16.9 million, of which $16.4 million was related to our ETFs. Our ETF portfolio is generally reflective of the performance in the broader domestic stock markets. During the first quarter of 2020, the fair values our ETFs declined by $13.1 million, driven by the disruption in the financial markets associated with the COVID-19 pandemic. The fair value of these funds rebounded sharply during the second quarter of 2020, gaining back a substantial portion of the decline in value, and fair values continued to increase during the latter half of 2020 on an improving outlook. For the year ended December 31, 2019, we recognized unrealized gains related to our equity portfolio of $12.4 million and was reflective of gains in the broader stock markets during this period. Net capital gains were $3.5 million for the year ended December 31, 2020, primarily due to the sale of corporate bonds to realize favorable investment valuations. We perform quarterly reviews of all available-for-sale securities within our investment portfolio to determine whether the decline in a security's fair value is deemed to be a credit loss. Management concluded that there were no credit losses (previously known as other-than-temporary impairments) from available-for-sale investments for the year ended December 31, 2020 or 2019. 47 Table of Contents Income tax expense Our effective tax rate was approximately 11.9% for the year ended December 31, 2020 compared to 16.7% for the year ended December 31, 2019. The effective tax rate was lower than the federal statutory rate of 21% primarily due to the tax benefits from stock-based compensation and tax-exempt investment income. Return on equity Our return on equity was 18.0% for the year ended December 31, 2020 compared to 18.9% for the year ended December 31, 2019. Operating return on equity was 14.7% for the full year of 2020, a decrease from 15.9% for the full year of 2019. The decrease in the operating return on equity was due largely to the proceeds received from our equity offering in the third quarter of 2020 and catastrophe losses incurred during the year, offset in part by higher net income. Liquidity and Capital Resources Sources and uses of funds We are organized as a Delaware holding company with our operations primarily conducted by our wholly-owned insurance subsidiary, Kinsale Insurance, which is domiciled in Arkansas. Accordingly, Kinsale may receive cash through (1) loans from banks, (2) issuance of equity and debt securities, (3) corporate service fees from our insurance subsidiary, (4) payments from our subsidiaries pursuant to our consolidated tax allocation agreement and other transactions and (5) dividends from our insurance subsidiary. We may use the proceeds from these sources to contribute funds to Kinsale Insurance in order to support premium growth, reduce our reliance on reinsurance, pay dividends and taxes and for other business purposes. We receive corporate service fees from Kinsale Insurance to reimburse us for most of the operating expenses that we incur. Reimbursement of expenses through corporate service fees is based on the actual costs that we expect to incur with no mark-up above our expected costs. We file a consolidated federal income tax return with our subsidiaries, and under our corporate tax allocation agreement, each participant is charged or refunded taxes according to the amount that the participant would have paid or received had it filed on a separate return basis with the Internal Revenue Service. State insurance laws restrict the ability of Kinsale Insurance to declare stockholder dividends without prior regulatory approval. State insurance regulators require insurance companies to maintain specified levels of statutory capital and surplus. The maximum dividend distribution Kinsale Insurance may make absent the approval or non-disapproval of the insurance regulatory authority in Arkansas is limited by Arkansas law to the greater of (1) 10% of policyholder surplus as of December 31 of the previous year, or (2) net income, not including realized capital gains, for the previous calendar year. The Arkansas statute also requires that dividends and other distributions be paid out of positive unassigned surplus without prior approval. The maximum amount of dividends Kinsale Insurance can pay us during 2021 without regulatory approval is $51.8 million. Insurance regulators have broad powers to ensure that statutory surplus remains at adequate levels, and there is no assurance that dividends of the maximum amount calculated under any applicable formula would be permitted. In the future, state insurance regulatory authorities that have jurisdiction over the payment of dividends by Kinsale Insurance may adopt statutory provisions more restrictive than those currently in effect. Kinsale Insurance did not pay dividends to us during 2020. See also "Risk Factors — Risks Related to Our Business and Our Industry — Because we are a holding company and substantially all of our operations are conducted by our insurance subsidiary, our ability to pay dividends depends on our ability to obtain cash dividends or other permitted payments from our insurance subsidiary." 48 Table of Contents As of December 31, 2020, our holding company had $8.4 million in cash and investments, compared to $14.7 million as of December 31, 2019. Management believes there is sufficient liquidity available at the holding company and in its insurance subsidiary, Kinsale Insurance, as well as in its other operating subsidiaries, to meet its operating cash needs and obligations and committed capital expenditures for the next 12 months. Credit agreement On May 28, 2019, we entered into a Credit Agreement that provided us with a $50 million Credit Facility (the "Credit Facility") and an uncommitted accordion feature that permits the Company to increase the commitments by an additional $30 million. The Credit Facility has a maturity of May 28, 2024. Borrowings under the Credit Facility were used to fund the construction of our new headquarters but may also be used for working capital and general corporate purposes. As of December 31, 2020, there was $42.6 million outstanding under the Credit Facility, net of debt issuance costs. Loans under the Credit Facility may be subject to varying rates of interest depending on whether the loan is a Eurodollar loan or an alternate base rate (ABR) loan, at the Company's election. Eurodollar loans bear an interest rate per annum equal to adjusted LIBOR for the applicable interest period plus a margin of 1.75%. ABR loans bear an interest rate per annum equal to the higher of the prime rate, the New York Federal Reserve Board Rate or the one-month adjusted LIBOR, plus the applicable margin of 0.75% or 1.75%, depending on which interest option was applicable for the particular ABR loan. The Credit Agreement also contains representations and warranties and affirmative and negative covenants customary for financings of this type, as well as customary events of default. As of December 31, 2020, the Company was in compliance with all of its financial covenants under the Credit Facility. In July 2017, the U.K. Financial Conduct Authority announced that, after the end of 2021, it would no longer persuade or compel contributing banks to make rate submissions to the ICE Benchmark Administration (together with any successor to the ICE Benchmark Administrator, the “IBA”) for purposes of the IBA setting the London interbank offered rate. On November 30, 2020, the IBA announced a consultation on its intention to 1) cease the publication of the one-week and two-month USD LIBOR after December 31, 2021, and 2) cease the publication of all other tenors of USD LIBOR after June 30, 2023, including the three-month USD LIBOR rate. The IBA closed the consultations for feedback at the end of January 2021. The Credit Agreement provides procedures for determining a replacement or alternative base rate in the event that LIBOR is discontinued. However, there can be no assurances as to whether such replacement or alternative base rate will be more or less favorable than LIBOR. The Company intends to monitor the developments with respect to the potential phasing out of LIBOR and work with its lenders to seek to ensure any transition away from LIBOR will have minimal impact on its financial condition, but can provide no assurances regarding the impact of the discontinuation of LIBOR. Shelf registration In August 2019, we filed a universal shelf registration statement with the SEC that expires in 2022. We can use this shelf registration to issue an unspecified amount of debt securities, common stock, preferred stock, depositary shares and warrants. The specific terms of any securities we issue under this registration statement will be provided in the applicable prospectus supplements. On August 7, 2020, we completed an underwritten public offering and sold and issued 310,500 shares of our common stock at a price of $190 per share. After deducting underwriting discounts and commissions, we received net proceeds of $56.7 million, which was used for general corporate purposes, including to fund organic growth. 49 Table of Contents Cash flows Our most significant source of cash is from premiums received from our insureds, which, for most policies, we receive at the beginning of the coverage period. Our most significant cash outflow is for claims that arise when a policyholder incurs an insured loss. Because the payment of claims occurs after the receipt of the premium, often years later, we invest the cash in various investment securities that earn interest and dividends. We also use cash to pay commissions to brokers, as well as to pay for ongoing operating expenses such as salaries, consulting services and taxes. As described under "—Reinsurance" below, we use reinsurance to manage the risk that we take on our policies. We cede, or pay out, part of the premiums we receive to our reinsurers and collect cash back when losses subject to our reinsurance coverage are paid. The timing of our cash flows from operating activities can vary among periods due to the timing by which payments are made or received. Some of our payments and receipts, including loss settlements and subsequent reinsurance receipts, can be significant, so their timing can influence cash flows from operating activities in any given period. Management believes that cash receipts from premiums, proceeds from investment sales and redemptions and investment income are sufficient to cover cash outflows in the foreseeable future. Our cash flows for the years ended December 31, 2020 and 2019 were: Year Ended December 31, 2020 2019 (in thousands) Cash and cash equivalents provided by (used in): Operating activities $ 279,974 $ 178,357 Investing activities (379,433) (230,793) Financing activities 76,144 77,755 Change in cash and cash equivalents $ (23,315) $ 25,319 We have historically generated positive operating cash flows. The increase in cash provided by operating activities in 2020 compared to 2019 was due primarily to growth in business and the timing of claim payments and reinsurance recoverable balances. Cash flows from operations were used to fund investing activities and to pay dividends to our stockholders. Net cash used in investing activities increased by $148.6 million in 2020 from 2019, which reflected growth in our business operations and proceeds from our equity offering in August 2020 of $56.7 million. For the year ended December 31, 2020, these funds were used to purchase fixed-maturity securities, particularly corporate bonds and asset- and mortgage-backed securities of $474.8 million, and to a lesser extent, municipal bonds of $54.8 million and U.S. Treasuries of $1.1 million. During 2020, we received proceeds of $119.7 million from sales of fixed-maturity securities, largely corporate bonds in order to take advantage of favorable valuations. In addition, we received proceeds of $93.8 million from redemptions of asset- and mortgage-backed securities and corporate bonds. For the year ended December 31, 2020, purchases of ETFs and non-redeemable preferred stock were $27.2 million and $9.6 million, respectively. Net cash used in investing activities included net purchases of property and equipment of $27.8 million, primarily related to the construction of our new corporate headquarters, previously discussed. For the year ended December 31, 2019, net cash used in investing activities of $230.8 million reflected the investment of operating funds from growth in our business operations and proceeds from our equity offering in August of 2019. These cash inflows were used to purchase fixed-maturity securities, particularly corporate bonds and residential mortgage-backed securities of $203.0 million, and to a lesser extent, other asset-backed securities of 50 Table of Contents $60.4 million and municipal bonds of $42.8 million. During 2019, we received proceeds of $35.5 million from sales of fixed-maturity securities, largely municipal bonds in order to take advantage of favorable valuations. In addition, we received proceeds of $67.9 million from redemptions of asset- and mortgage-backed securities and corporate bonds. During 2019, the Company reallocated its ETFs from foreign and small-cap funds to domestic equity funds to more closely mirror the broader U.S. stock market. For the year ended December 31, 2019, purchases and sales of ETFs were $19.3 million and $13.7 million, respectively. For the year ended December 31, 2019, purchases and sales of non-redeemable preferred stocks were $10.6 million and $7.8 million, respectively. Net cash used in investing activities during 2019 included purchases of property and equipment of $19.6 million and was principally comprised of expenditures related to the construction of our new corporate headquarters, discussed previously. For the year ended December 31, 2020, net cash provided by financing activities was $76.1 million and reflected the proceeds from our equity offering of $56.7 million, previously discussed, and the drawdown of $25.7 million on our Credit Facility, which was used to fund construction of our new headquarter facilities. During the year ended December 31, 2020, we paid dividends of $0.36 per common share, or $8.1 million in the aggregate. Proceeds received from our equity compensation plans were $3.6 million, offset by payroll taxes withheld and remitted on restricted stock awards of $1.8 million for the year ended December 31, 2020. For the year ended December 31, 2019, net cash provided by financing activities was $77.8 million and reflected the proceeds from our equity offering of $65.9 million, previously discussed, and the drawdown of $17.3 million on our Credit Facility, which was used to fund construction of our new headquarter facilities. During year ended December 31, 2019 we paid dividends of $0.32 per common share, or $6.9 million in the aggregate. During 2019, we received net proceeds of $2.1 million from our equity compensation plans. Reinsurance We enter into reinsurance contracts to limit our exposure to potential large losses as well as to provide additional capacity for growth. Our reinsurance is primarily contracted under quota-share reinsurance contracts and excess of loss contracts. In quota-share reinsurance, the reinsurer agrees to assume a specified percentage of the ceding company's losses arising out of a defined class of business in exchange for a corresponding percentage of premiums, net of a ceding commission. In excess of loss reinsurance, the reinsurer agrees to assume all or a portion of the ceding company's losses, in excess of a specified amount. In excess of loss reinsurance, the premium payable to the reinsurer is negotiated by the parties based on their assessment of the amount of risk being ceded to the reinsurer because the reinsurer does not share proportionately in the ceding company's losses. For the year ended December 31, 2020, property insurance represented 14.4% of our gross written premiums. When we write property insurance, we buy reinsurance to significantly mitigate our risk. We use computer models to analyze the risk of severe losses from weather-related events and earthquakes. We measure exposure to these catastrophe losses in terms of PML, which is an estimate of what level of loss we would expect to experience in a windstorm or earthquake event occurring once in every 100 or 250 years. We manage this PML by purchasing catastrophe reinsurance coverage. Effective June 1, 2020, we purchased catastrophe reinsurance coverage of $45.0 million per event in excess of our $10.0 million per event retention. Our property catastrophe reinsurance includes a reinstatement provision which requires us to pay reinstatement premiums after a loss has occurred in order to preserve coverage. Including the reinstatement provision, the maximum aggregate loss recovery limit is $90 million and is in addition to the per-occurrence coverage provided by our facultative and treaty coverages. Reinsurance contracts do not relieve us from our obligations to policyholders. Failure of the reinsurer to honor its obligation could result in losses to us, and therefore, we established an allowance for credit risk based on historical analysis of credit losses for highly rated companies in the insurance industry. The Company evaluates the financial condition of its reinsurers and monitors concentration of credit risk arising from its exposure to individual reinsurers. 51 Table of Contents As of December 31, 2020, Kinsale Insurance has only contracted with reinsurers with A.M. Best financial strength ratings of "A" (Excellent) or better. At December 31, 2020, the net reinsurance receivable, defined as the sum of paid and unpaid reinsurance recoverables, ceded unearned premiums less reinsurance payables, from five reinsurers represented 78.1% of the total balance. During 2020, we adopted new accounting guidance ASU 2016-13, Financial Instruments – Credit Losses (Topic 326) a nd, as a result, we recorded an allowance for doubtful accounts of $0.3 million related to our reinsurance balances at December 31, 2020. Ratings Kinsale Insurance has a financial strength rating of "A" (Excellent) from A.M. Best. A.M. Best assigns ratings to insurance companies, which currently range from "A++" (Superior) to "F" (In Liquidation). "A" (Excellent) is the third highest rating issued by A.M. Best. The "A" (Excellent) rating is assigned to insurers that have, in A.M. Best's opinion, an excellent ability to meet their ongoing obligations to policyholders. This rating is intended to provide an independent opinion of an insurer's ability to meet its obligation to policyholders and is not an evaluation directed at investors. See also "Risk Factors — Risks Related to Our Business and Our Industry — A decline in our financial strength rating may adversely affect the amount of business we write." The financial strength ratings assigned by A.M. Best have an impact on the ability of the insurance companies to attract and retain agents and brokers and on the risk profiles of the submissions for insurance that the insurance companies receive. The "A" (Excellent) rating obtained by Kinsale Insurance is consistent with our business plan and allows us to actively pursue relationships with the agents and brokers identified in our marketing plan. Contractual obligations and commitments The following table illustrates our contractual obligations and commercial commitments by due date as of December 31, 2020: Payments Due by Period Total Less Than One Year One Year to Less Than Three Years Three Years to Less Than Five Years More Than Five Years (in thousands) Reserves for losses and loss adjustment expenses $ 636,013 $ 132,507 $ 213,669 $ 124,936 $ 164,901 Credit facility 45,871 846 1,686 43,339 — Total $ 681,884 $ 133,353 $ 215,355 $ 168,275 $ 164,901 Reserves for losses and loss adjustment expenses Reserves for losses and loss adjustment expenses represent our best estimate of the ultimate cost of settling reported and unreported claims and related expenses. As discussed previously, the estimation of loss and loss expense reserves is based on various complex and subjective judgments. Actual losses and settlement expenses paid may deviate, perhaps substantially, from the reserve estimates reflected in our consolidated financial statements. Similarly, the timing for payment of our estimated losses is not fixed and is not determinable on an individual or aggregate basis. The assumptions used in estimating the payments due by period are based on Company experience as well as on industry and peer-group claims payment experience. Due to the uncertainty inherent in the process of estimating the timing of such payments, there is a risk that the amounts paid in any period can be significantly different than the amounts disclosed above. Amounts disclosed above are gross of anticipated amounts recoverable from reinsurers. Reinsurance balances recoverable on reserves for losses and loss adjustment expenses are reported 52 Table of Contents separately as assets, instead of being netted with the related liabilities, since reinsurance does not discharge us of our liability to policyholders. Reinsurance balances recoverable on reserves for paid and unpaid losses and loss adjustment expenses totaled $93.2 million at December 31, 2020. Credit facility As of December 31, 2020, we had $42.6 million outstanding under the Credit Facility, which has a maturity of May 28, 2024. Interest on the outstanding amounts is estimated based on 3-month LIBOR plus a margin of 1.75%. Current borrowings under the Credit Facility were used to fund construction of our new headquarters, which was substantially complete at December 31, 2020. However, we may decide to repay the Credit Facility without penalty and as a result, actual amounts paid and the associated interest may differ from the estimates presented. Financial Condition Stockholders' equity At December 31, 2020, total stockholders' equity was $576.2 million and tangible stockholders' equity was $573.4 million, compared to total stockholders' equity of $405.9 million and tangible stockholders' equity of $403.1 million at December 31, 2019. The increase in both total stockholders' equity and tangible stockholders' equity in 2020 compared to 2019 was primarily due to profits generated during the period, proceeds received from the public equity offering in August of 2020, an increase in unrealized gains on available-for-sale investments, net of taxes, and net activity related to stock-based compensation plans. These increases were offset in part by the dividends declared during 2020. Tangible stockholders’ equity is a non-GAAP financial measure. See "—Reconciliation of non-GAAP financial measures" for a reconciliation of stockholders' equity in accordance with GAAP to tangible stockholders' equity. Equity-based compensation On July 27, 2016, the Kinsale Capital Group, Inc. 2016 Omnibus Incentive Plan (the "2016 Incentive Plan"), became effective. The 2016 Incentive Plan provides for grants of stock options, restricted stock, restricted stock units and other stock-based awards to directors, officers and other employees, as well as independent contractors or consultants providing consulting or advisory services to the Company. The number of shares of common stock available for issuance under the 2016 Incentive Plan may not exceed 2,073,832. During 2020, 42,694 shares of restricted stock awards were granted under the 2016 Incentive Plan to the Company’s employees and non-employee directors. The restricted stock had a weighted average fair value on the date of grant of $147.45 per share and vest over a term of 1 to 4 years. On January 1, 2021, the Board of Directors granted 3,200 shares of restricted stock awards under the 2016 Incentive Plan to the Company’s non-employee directors. The restricted stock had a fair value on the date of grant of $200.13 per share and will vest on the first anniversary date of the grant. Dividend declarations On February 13, 2020, the Company’s Board of Directors declared a cash dividend of $0.09 per share of common stock. This dividend was paid on March 12, 2020 to all stockholders of record on February 28, 2020. On May 21, 2020, the Company’s Board of Directors declared a cash dividend of $0.09 per share of common stock. This dividend was paid on June 12, 2020 to all stockholders of record on June 2, 2020. On August 18, 2020, the Company’s Board of Directors declared a cash dividend of $0.09 per share of common stock. This dividend was paid on September 14, 2020 to all stockholders of record on August 31, 2020. 53 Table of Contents On November 11, 2020, the Company’s Board of Directors declared a cash dividend of $0.09 per share of common stock. This dividend was paid on December 11, 2020 to all stockholders of record on November 30, 2020. On February 11, 2021, the Company’s Board of Directors declared a cash dividend of $0.11 per share of common stock. This dividend is payable on March 12, 2021 to all stockholders of record on February 26, 2021. Investment portfolio At December 31, 2020, o ur cash and invested assets of $1.3 billion consisted of fixed-maturity securities, cash and cash equivalents and equity securities. At December 31, 2020, the majority of the investment portfolio was comprised of fixed-maturity securities of $1.1 billion that were classified as available-for-sale. Available-for-sale investments are carried at fair value with unrealized gains and losses on those securities, net of applicable taxes, reported as a separate component of accumulated other comprehensive income. At December 31, 2020, we also held $77.1 million of cash and cash equivalents and $129.7 million of equity securities, which are comprised of ETFs and non-redeemable preferred stock. Our fixed-maturity securities, including cash equivalents, had a weighted average duration of 4.3 years and an average rating of "AA-" at December 31, 2020. Our investment portfolio, excluding cash equivalents, had a gross return of 2.9% as of December 31, 2020, compared to 3.1% as of December 31, 2019. At December 31, 2020, the amortized cost and estimated fair value of our investments were as follows: December 31, 2020 Amortized Cost Estimated Fair Value % of Total Fair Value ($ in thousands) Fixed maturities: Obligations of states, municipalities and political subdivisions $ 216,181 $ 230,906 19.1 % Corporate and other securities 294,854 316,608 26.1 % Asset-backed securities 236,813 240,661 19.9 % Commercial mortgage-backed securities 66,110 70,969 5.8 % Residential mortgage-backed securities 217,859 222,656 18.4 % Total fixed maturities 1,031,817 1,081,800 89.3 % Equity securities: Exchange traded funds 68,032 98,050 8.1 % Nonredeemable preferred stock 30,726 31,612 2.6 % Total equity securities 98,758 129,662 10.7 % Total investments $ 1,130,575 $ 1,211,462 100.0 % 54 Table of Contents The table below summarizes the credit quality of our fixed-maturity securities as of December 31, 2020, as rated by Standard & Poor’s Financial Services, LLC ("Standard & Poor's") or equivalent designation: December 31, 2020 Standard & Poor’s or Equivalent Designation Estimated Fair Value % of Total ($ in thousands) AAA $ 312,721 28.9 % AA 382,174 35.3 % A 187,970 17.4 % BBB 157,777 14.6 % Below BBB 41,158 3.8 % Total $ 1,081,800 100.0 % The amortized cost and estimated fair value of our available-for-sale investments in fixed-maturity securities summarized by contractual maturity as of December 31, 2020, were as follows: December 31, 2020 Amortized Cost Estimated Fair Value % of Fair Value ($ in thousands) Due in one year or less $ 15,545 $ 15,782 1.5 % Due after one year through five years 107,150 115,390 10.7 % Due after five years through ten years 156,958 169,711 15.7 % Due after ten years 231,382 246,631 22.8 % Asset-backed securities 236,813 240,661 22.2 % Commercial mortgage-backed securities 66,110 70,969 6.5 % Residential mortgage-backed securities 217,859 222,656 20.6 % Total fixed maturities $ 1,031,817 $ 1,081,800 100.0 % Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties, and the lenders may have the right to put the securities back to the borrower. Restricted investments In order to conduct business in certain states, we are required to maintain letters of credit or assets on deposit to support state-mandated insurance regulatory requirements and to comply with certain third-party agreements. Assets held on deposit or in trust accounts are primarily in the form of cash or certain high-grade securities. The fair value of our restricted assets was $6.9 million at December 31, 2020 and 2019. Off-balance sheet arrangements We do not have any material off-balance sheet arrangements as of December 31, 2020. 55 Table of Contents Reconciliation of Non-GAAP Financial Measures Reconciliation of underwriting income Underwriting income is a non-GAAP financial measure that we believe is useful in evaluating our underwriting performance without regard to investment income. Underwriting income is defined as net income excluding net investment income, the net change in the fair value of equity securities, net realized gains and losses on investments, other income, other expenses and income tax expense. We use underwriting income as an internal performance measure in the management of our operations because we believe it gives us and users of our financial information useful insight into our results of operations and our underlying business performance. Underwriting income should not be viewed as a substitute for net income calculated in accordance with GAAP, and other companies may define underwriting income differently. Net income for the years ended December 31, 2020, 2019, 2018, 2017 and 2016 reconciles to underwriting income as follows: Year Ended December 31, ($ in thousands) 2020 2019 2018 2017 2016 Net income $ 88,419 $ 63,316 $ 33,787 $ 24,901 $ 26,167 Income tax expense 11,994 12,735 6,693 13,620 13,369 Income before taxes 100,413 76,051 40,480 38,521 39,536 Other expenses 1,375 57 168 429 2,567 Net investment income (26,110) (20,133) (15,688) (10,569) (7,487) Change in the fair value of equity securities (16,855) (12,389) 6,555 — — Net realized investment gains (3,533) (359) (281) (151) (176) Other income (634) (26) (12) (3) (136) Underwriting income $ 54,656 $ 43,201 $ 31,222 $ 28,227 $ 34,304 Reconciliation of adjusted loss ratio, adjusted expense ratio and adjusted combined ratio Our adjusted loss ratio, adjusted expense ratio and adjusted combined ratio are non-GAAP financial measures. We define our adjusted loss ratio, adjusted expense ratio and adjusted combined ratio as each of our loss ratio, expense ratio and combined ratio, respectively, excluding the effects of the MLQS. We use these adjusted ratios as an internal performance measure in the management of our operations because we believe they give our management and other users of our financial information useful insight into our results of operations and our underlying business performance. Our adjusted loss ratio, adjusted expense ratio and adjusted combined ratio should not be viewed as substitutes for our loss ratio, expense ratio and combined ratio, respectively, which are presented in accordance with GAAP. 56 Table of Contents The effect of the MLQS on our results of operations is primarily reflected in our ceded written premiums, losses and loss adjustment expenses, as well as our underwriting, acquisition and insurance expenses. The following table summarize the effect of the MLQS on our underwriting income for the year ended December 31, 2016: Year Ended December 31, 2016 ($ in thousands) Including Quota Share Effect of Quota Share Excluding Quota Share Net earned premiums $ 133,816 $ (16,996) $ 150,812 Losses and loss adjustment expenses (70,961) 4,380 (75,341) Underwriting, acquisition and insurance expenses (28,551) 11,936 (40,487) Underwriting income $ 34,304 $ (680) $ 34,984 Loss ratio 53.0 % 25.8 % — Expense ratio 21.3 % 70.2 % — Combined ratio 74.3 % 96.0 % — Adjusted loss ratio — — 50.0 % Adjusted expense ratio — — 26.8 % Adjusted combined ratio — — 76.8 % Reconciliation of net operating earnings Net operating earnings is defined as net income excluding the effects of the net change in the fair value of equity securities, after taxes, and net realized gains and losses on investments, after taxes, as well as the earnings impact of the deferred tax revaluation recognized resulting from the enactment of the TCJA in December 2017. Management believes the exclusion of these items provides a more useful comparison of the Company's underlying business performance from period to period. Net operating earnings and percentages or calculations using net operating earnings (e.g., operating return on equity) are non-GAAP financial measures. Net operating earnings should not be viewed as a substitute for net income calculated in accordance with GAAP, and other companies may define net operating earnings differently. Net income for the years ended December 31, 2020, 2019, 2018, 2017 and 2016 reconcile to net operating earnings as follows: Year Ended December 31, ($ in thousands) 2020 2019 2018 2017 2016 Net income $ 88,419 $ 63,316 $ 33,787 $ 24,901 $ 26,167 Change in the fair value of equity securities, after taxes (13,315) (9,787) 5,178 — — Net realized gains on investments, after taxes (2,791) (284) (222) (98) (114) TCJA charge — — — 1,915 — Net operating earnings $ 72,313 $ 53,245 $ 38,743 $ 26,718 $ 26,053 Operating return on equity: Average equity (1) $ 491,059 $ 334,933 $ 251,088 $ 224,202 $ 161,833 Return on equity (2) 18.0 % 18.9 % 13.5 % 11.1 % 16.2 % Operating return on equity (3) 14.7 % 15.9 % 15.4 % 11.9 % 16.1 % 57 Table of Contents (1) Computed by adding the total stockholders' equity as of the date indicated to the prior year-end total and dividing by two. (2) Return on equity represents net income expressed as a percentage of average beginning and ending stockholders’ equity during the period. (3) Operating return on equity is net operating earnings expressed as a percentage of average beginning and ending stockholders’ equity during the period. Reconciliation of tangible stockholders' equity Tangible stockholders’ equity is a non-GAAP financial measure. We define tangible stockholders’ equity as stockholders’ equity less intangible assets, net of deferred taxes. Our definition of tangible stockholders’ equity may not be comparable to that of other companies, and it should not be viewed as a substitute for stockholders’ equity calculated in accordance with GAAP. We use tangible stockholders' equity internally to evaluate the strength of our balance sheet and to compare returns relative to this measure. Stockholders' equity at December 31, 2020, 2019, 2018, 2017, and 2016, reconciles to tangible stockholders' equity as follows: December 31, 2020 2019 2018 2017 2016 (in thousands) Stockholders' equity $ 576,238 $ 405,880 $ 263,986 $ 238,189 $ 210,214 Less: Intangible assets, net of deferred taxes 2,795 2,795 2,795 2,795 2,300 Tangible stockholders' equity $ 573,443 $ 403,085 $ 261,191 $ 235,394 $ 207,914 Critical Accounting Estimates We identified the accounting estimates which are critical to the understanding of our financial position and results of operations. Critical accounting estimates are defined as those estimates that are both important to the portrayal of our financial condition and results of operations and require us to exercise significant judgment. We use significant judgment concerning future results and developments in applying these critical accounting estimates and in preparing our consolidated financial statements. These judgments and estimates affect our reported amounts of assets, liabilities, revenues and expenses and the disclosure of our material contingent assets and liabilities, if any. Actual results may differ materially from the estimates and assumptions used in preparing the consolidated financial statements. We evaluate our estimates regularly using information that we believe to be relevant. For a detailed discussion of our accounting policies, see the "Notes to Consolidated Financial Statements" included in this Annual Report on Form 10-K. Reserves for unpaid losses and loss adjustment expenses The reserves for unpaid losses and loss adjustment expenses are the largest and most complex estimate in our consolidated balance sheet. The reserves for unpaid losses and loss adjustment expenses represent our estimated ultimate cost of all unreported and reported but unpaid insured claims and the cost to adjust these losses that have occurred as of or before the consolidated balance sheet date. As a relatively new company, our historical loss experience is limited. We estimate the reserves using individual case-basis valuations of reported claims and statistical analyses. Those estimates are based on our historical information, industry information and our estimates of future trends in variable factors such as loss severity, loss frequency and other factors such as inflation. We regularly review our estimates and adjust them as necessary as experience develops or as new information becomes 58 Table of Contents known to us. Such adjustments are included in current operations. Additionally, during the loss settlement period, it often becomes necessary to refine and adjust the estimates of liability on a claim either upward or downward. Even after such adjustments, ultimate liability may exceed or be less than the revised estimates. Accordingly, the ultimate settlement of losses and the related loss adjustment expenses may vary significantly from the estimate included in our consolidated financial statements. We categorize our reserves for unpaid losses and loss adjustment expenses into two types: case reserves and reserves for incurred but not reported losses ("IBNR"). Our gross reserves for losses and loss adjustment expenses at December 31, 2020 were $636.0 million, and of this amount, 84.2% related to IBNR. Our reserves for losses and loss adjustment expenses, net of reinsurance, at December 31, 2020 were $552.3 million, and of this amount, 84.9% related to IBNR. A 5% change in net IBNR reserves at December 31, 2020 would equate to an $23.4 million change in the reserve for losses and loss adjustment expenses at such date, as well as $18.5 million change in net income, a 3.2% change in both stockholders' equity and tangible stockholders' equity, in each case at or for the year ended December 31, 2020. The following tables summarize our reserves for unpaid losses and loss adjustment expenses, on a gross basis and net of reinsurance, at December 31, 2020 and 2019: December 31, 2020 Gross % of Total Net % of Total ($ in thousands) Case reserves $ 100,628 15.8 % $ 83,638 15.1 % IBNR 535,385 84.2 468,645 84.9 Total $ 636,013 100.0 % $ 552,283 100.0 % December 31, 2019 Gross % of Total Net % of Total ($ in thousands) Case reserves $ 82,113 17.8 % $ 65,588 16.8 % IBNR 377,945 82.2 324,678 83.2 Total $ 460,058 100.0 % $ 390,266 100.0 % Case reserves are established for individual claims that have been reported to us. We are notified of losses by our insureds or their brokers. Based on the information provided, we establish case reserves by estimating the ultimate losses from the claim, including defense costs associated with the ultimate settlement of the claim. Our claims department personnel use their knowledge of the specific claim along with advice from internal and external experts, including underwriters and legal counsel, to estimate the expected ultimate losses. During the life cycle of a particular claim, as more information becomes available, we may revise our estimate of the ultimate value of the claim either upward or downward. The amount of the individual claim reserve is based on the most recent information available. IBNR reserves are determined using actuarial methods to estimate losses that have occurred but have not yet been reported to us. We principally use the incurred Bornhuetter-Ferguson actuarial method ("BF method") to arrive at our loss reserve estimates for each line of business. This method estimates the reserves based on our initial expected loss ratio and expected reporting patterns for losses. Because we have a limited number of years of loss experience compared to the period over which we expect losses to be reported, we use industry and peer-group data, in addition to our own data, as a basis for selecting our expected reporting patterns. Since the incurred BF method does not directly use reported losses in the estimation of IBNR, it is less sensitive to our level of reported losses than other actuarial methods. This method avoids some of the distortions that could result from a large loss development factor 59 Table of Contents being applied to a small base of reported losses to calculate ultimate losses. However, this method will react more slowly than some other loss development methods if reported loss experience deviates significantly from our expected losses. Our Reserve Committee consists of our Chief Actuary, Chief Executive Officer, Chief Operating Officer and Chief Financial Officer. The Reserve Committee meets quarterly to review the actuarial recommendations made by the Chief Actuary. In establishing the actuarial recommendation for the reserves for losses and loss adjustment expenses, our actuary estimates an initial expected ultimate loss ratio for our statutory lines of business by accident year. Input from our underwriting and claims departments, including premium pricing assumptions and historical experience, is considered by our actuary in estimating the initial expected loss ratios. During each quarter, the Reserve Committee reviews the emergence of actual losses relative to expectations by line of business to assess whether the assumptions used in the reserving process continue to form a reasonable basis for the projection of liabilities for those product lines. Our reserving methodology uses a loss reserving model that calculates a point estimate for our ultimate losses. Although we believe that our assumptions and methodology are reasonable, our ultimate payments may vary, potentially materially, from the estimates we have made. In addition, we retain an independent external actuary annually to assist us in determining if the reserve levels are reasonable. The independent actuary is not involved in the establishment and recording of our loss reserve. The actuarial consulting firm prepares its own estimate of our reserves for loss and loss adjustment expenses, and we compare their estimate to the reserves for losses and loss adjustment expenses reviewed and approved by the Reserve Committee in order to gain additional comfort on the adequacy of those reserves. The table below quantifies the impact of potential reserve deviations from our carried reserve at December 31, 2020. We applied sensitivity factors to incurred losses for the three most recent accident years and to the carried reserve for all prior accident years combined. We believe that potential changes such as these would not have a material impact on our liquidity. December 31, 2020 Potential Impact on 2020 Sensitivity Accident Year Net Ultimate Loss and LAE Sensitivity Factor Net Ultimate Incurred Losses and LAE Net Loss and LAE Reserve Pre-tax income Stockholders' Equity ($ in thousands) Sample increases 2020 10.0 % $ 277,140 $ 249,475 $ (27,714) $ (21,894) 2019 5.0 % 168,445 128,656 (8,422) (6,653) 2018 2.5 % 120,304 71,297 (3,008) (2,376) Prior 2.5 % 102,855 (2,571) (2,031) Sample decreases 2020 (10.0) % 277,140 249,475 27,714 21,894 2019 (5.0) % 168,445 128,656 8,422 6,653 2018 (2.5) % 120,304 71,297 3,008 2,376 Prior (2.5) % 102,855 2,571 2,031 Reserve development The amount by which estimated losses differ from those originally reported for a period is known as "development." Development is unfavorable when the losses ultimately settle for more than the amount reserved or subsequent estimates indicate a basis for reserve increases on unresolved claims. Development is favorable when losses ultimately settle for less than the amount reserved or subsequent estimates indicate a basis for reducing loss reserves 60 Table of Contents on unresolved claims. We reflect favorable or unfavorable development of loss reserves in the results of operations in the period the estimates are changed. During the year ended December 31, 2020, our net incurred losses for accident years 2019 and prior developed favorably by $13.3 million. This favorable development included $10.5 million for the 2019 accident year and $1.8 million for the 2018 accident year, which was primarily due to reported losses emerging at a lower level than expected, largely across the other liability and excess lines of business. During the year ended December 31, 2019, our net incurred losses for accident years 2018 and prior developed favorably by $9.4 million. This favorable development included $13.0 million for the 2018 accident year and $1.6 million for the 2017 accident year, which was primarily due to reported losses emerging at a lower level than expected, across most lines of business. The favorable development was offset in part by adverse development of $5.2 million for accident years 2015 and prior, primarily attributable to the other liability occurrence statutory line of business. This adverse development largely resulted from management’s decision to lengthen the actuarial loss development factors in certain lines to provide for emergence of reported losses over a longer period of time based on observed trends. Investments Fair value measurements Like other accounting estimates, fair value measurements may be based on subjective information and generally involve uncertainty and judgment. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Market participants are assumed to be independent, knowledgeable, able and willing to transact an exchange and not acting under duress. Fair value hierarchy disclosures are based on the quality of inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). Adjustments to transaction prices or quoted market prices may be required in illiquid or disorderly markets in order to estimate fair value. The three levels of the fair value hierarchy are described below: Level 1 - Inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities traded in active markets. Level 2 - Inputs to the valuation methodology include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability and market-corroborated inputs. Level 3 - Inputs to the valuation methodology are unobservable for the asset or liability and are significant to the fair value measurement. When the inputs used to measure fair value fall within different levels of the hierarchy, the level within which the fair value measurement is categorized is based on the lowest level input that is significant to the fair value measurement in its entirety. Thus, a Level 3 fair value measurement may include inputs that are observable (Level 1 and 2) and unobservable (Level 3). The use of valuation methodologies may require a significant amount of judgment. During periods of financial market disruption, including periods of rapidly widening credit spreads or illiquidity, it may be difficult to value certain of our securities if trading becomes less frequent or market data becomes less observable. We review the fair value hierarchy classifications on a quarterly basis. Changes in the observability of valuation inputs may result in a reclassification for certain financial assets and liabilities. Fair values of our investment portfolio are estimated using unadjusted prices obtained by our investment accounting vendor from nationally recognized third-party pricing services, where available. For securities where we are unable 61 Table of Contents to obtain fair values from a pricing service or broker, fair values are estimated using information obtained from our investment accounting vendor. We perform several procedures to ascertain the reasonableness of investment values included in the consolidated financial statements at December 31, 2020, including (1) obtaining and reviewing the internal control report from our investment accounting vendor that obtain fair values from third party pricing services, (2) discussing with our investment accounting vendor their process for reviewing and validating pricing obtained from outside pricing services and (3) reviewing the security pricing received from our investment accounting vendor and monitoring changes in unrealized gains and losses at the individual security level. Investment securities are subject to fluctuations in fair value due to changes in issuer-specific circumstances, such as credit rating, and changes in industry-specific circumstances, such as movements in credit spreads based on the market’s perception of industry risks. In addition, fixed maturities are subject to fluctuations in fair value due to changes in interest rates. As a result of these potential fluctuations, it is possible to have significant unrealized gains or losses on a security. Reinsurance We enter into reinsurance contracts to limit our exposure to potential large losses and to provide additional capacity for growth. Reinsurance refers to an arrangement in which a company called a reinsurer agrees in a contract (often referred to as a treaty) to assume specified risks written by an insurance company (known as a ceding company) by paying the insurance company all or a portion of the insurance company's losses arising under specified classes of insurance policies in return for a share in premiums. Reinsurance recoverables recorded on insurance losses ceded under reinsurance contracts are subject to judgments and uncertainties similar to those involved in estimating gross loss reserves. In addition to these uncertainties, our reinsurance recoverables may prove uncollectible if the reinsurers are unable or unwilling to perform under the reinsurance contracts. In establishing our reinsurance allowance for amounts deemed uncollectible, we evaluate the financial condition of our reinsurers and monitor concentration of credit risk arising from our exposure to individual reinsurers. To determine if an allowance is necessary, we consider, among other factors, published financial information, reports from rating agencies, payment history, collateral held and our legal right to offset balances recoverable against balances we may owe. Our reinsurance allowance for doubtful accounts is subject to uncertainty and volatility due to the time lag involved in collecting amounts recoverable from reinsurers. Over the period of time that losses occur, reinsurers are billed and amounts are ultimately collected, economic conditions, as well as the operational and financial performance of particular reinsurers may change and these changes may affect the reinsurers’ willingness and ability to meet their contractual obligations to us. It is difficult to fully evaluate the impact of major catastrophic events on the financial stability of reinsurers, as well as the access to capital that reinsurers may have when such events occur. The ceding of insurance does not legally discharge us from our primary liability for the full amount of the policies, and we will be required to pay the loss and bear the collection risk if any reinsurer fails to meet its obligations under the reinsurance contracts. We target reinsurers with A.M. Best financial strength ratings of "A" (Excellent) or better. Based on our evaluation of the factors discussed above, the allowance for uncollectible reinsurance was $0.3 million at December 31, 2020. See Note 1 to the consolidated financial statements – Recently adopted accounting pronouncements - ASU 2016-13, Financial Instruments – Credit Losses (Topic 326) for additional information. Recent Accounting Pronouncements Refer to Note 1 – "Summary of significant accounting policies" of the Notes to Consolidated Financial Statements for further discussion. 62 Table of Contents