ERIE INDEMNITY CO quarterly report, Q3 FY2017

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Business context and reporting period

Erie Indemnity Company’s unaudited Form 10-Q covers the quarter and nine months ended September 30, 2017, compared with the same 2016 periods. Indemnity acts as attorney-in-fact and management company for Erie Insurance Exchange, earning fees based on the Exchange’s premiums written; the Exchange conducts the insurance operations and is Indemnity’s sole customer.

Financial performance and position

  • Third quarter: Operating revenue rose 5.8% to $442.5 million; operating income fell 1.7% to $80.8 million; net income increased 2.0% to $58.5 million. Diluted Class A EPS was $1.12, up 2.2%.
  • Nine months: Operating revenue increased 6.0% to $1.290 billion; operating income decreased 2.2% to $230.4 million; net income edged up 0.2% to $164.9 million. Diluted Class A EPS was $3.15, up 0.4%.
  • Revenue and margins: Management fee revenue increased 5.9% in Q3 and 6.1% year to date. The fee rate remained at 25%, while Exchange premiums written grew 5.8% in Q3 and 6.0% in the nine-month period. Operating gross margin declined to 18.3% from 19.7% in Q3 and to 17.9% from 19.4% year to date.
  • Investment results: Total investment income grew 94.3% to $8.4 million in Q3 and 50.0% to $21.4 million year to date, aided by improved limited partnership results. Year-to-date net investment income was $18.2 million and realized gains were $1.5 million.
  • Cash flow: Operating cash flow was $120.3 million for the first nine months, down from $155.6 million. Investing used $40.4 million and financing used $84.4 million; cash declined $4.4 million to $184.6 million.
  • Balance sheet and liquidity: At September 30, total assets were $1.631 billion, shareholders’ equity $875.2 million, and available-for-sale securities $749.3 million. Receivables from the Exchange and affiliates were $428.5 million. Long-term borrowings were $49.7 million carrying value. The $100 million revolving line had no borrowings and $99.1 million available, net of letters of credit.
  • Dividends and shares: Dividends declared per Class A share were $0.7825 for Q3, up from $0.7300; nine-month dividends were $2.3475 versus $2.1900.

Material changes versus prior periods

  • Premium growth, higher policies in force, and higher average premiums lifted management fee revenue. Exchange policy retention was 89.6% at September 30, 2017, versus 89.8% a year earlier.
  • Expenses grew faster than revenue: total operating expenses rose 7.6% in Q3 and 8.0% year to date. Commissions increased with premiums and agent incentives; year-to-date information technology costs rose 17.3%, and administrative and other costs rose 25.4%.
  • Operating cash flow declined primarily because of higher agent payments, general operating costs, and pension contributions. Indemnity contributed $39.0 million to its pension plan during the first nine months.
  • The Exchange and its property-casualty subsidiaries reported statutory surplus of $8.4 billion at September 30, 2017, versus $7.7 billion at December 31, 2016; their A.M. Best rating was affirmed at A+ with a stable outlook.

Outlook, risks, and unusual items

  • No specific earnings or revenue guidance is provided. Management expects normal operating cash needs to be met from operations and says it has cash, credit availability, and investment assets as additional funding sources. The Exchange intends to continue premium growth and market-penetration efforts.
  • Principal risks include dependence on the Exchange’s growth and financial condition, concentrated unsecured receivables from the Exchange, agency relationships, competition, catastrophe losses, regulation, investment-market volatility, technology or cyber disruption, and litigation.
  • A headquarters construction project has a guaranteed maximum cost of $100 million, subject to scope changes, with substantial completion expected in January 2020. The term loan facility is up to $100 million; $50 million had been drawn at quarter-end. Further scheduled draws were expected in 2017 and 2018, with principal repayment beginning in 2019.
  • Litigation over service and related charges includes a state-court matter with plaintiffs’ allegations referring to approximately $308 million. The related federal Beltz II case was dismissed in its entirety in July 2017, and plaintiffs appealed in August. The state-court motion to stay and amended objections remained pending. The company says it intends to defend the claims; the filing does not state a clear estimate of potential loss.
  • The company disclosed a $19.7 million contingent exposure if Erie Family Life does not honor certain pension annuity contracts. It also had $16.4 million of limited-partnership investment commitments.
  • Management reported effective disclosure controls and no material change in internal control over financial reporting during the nine months. No material market-risk changes were reported.

Important facts for investors to verify

  1. Whether Exchange premium growth and retention persist, and how changes in premiums or the 25% management fee rate affect Indemnity.
  2. Whether expense growth—particularly commissions, technology, personnel, and incentives—continues to outpace revenue and pressure operating margins.
  3. The trajectory of operating cash flow, pension funding, and the planned term-loan draws and headquarters construction spending.
  4. Developments in the service-charge lawsuits, including the appeal and any change in the company’s assessment or ability to estimate potential exposure.
  5. The collectability of the $428.5 million Exchange-related receivable and the effect of investment valuations, liquidity, and limited-partnership results, which are generally reported on a lag.