ERIE INDEMNITY CO quarterly report, Q2 FY2013

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Business context and reporting period

Erie Indemnity Company’s unaudited Form 10-Q covers the quarter and six months ended June 30, 2013. The consolidated statements include Indemnity and the Erie Insurance Exchange, whose policyholders’ interest is presented as noncontrolling interest. The Exchange owns the insurance operations; Indemnity principally earns a management fee for services to the Exchange.

Financial performance and position

Amounts are in millions of dollars, except per-share data and ratios.

  • Second quarter: Consolidated revenue was $1,426, up from $1,160; net income was $177 versus a $38 loss. Net income attributable to Indemnity was $44 versus $43, and diluted Class A EPS was $0.84 versus $0.80.
  • Six months: Consolidated revenue was $2,997 versus $2,680; net income was $467 versus $316. Indemnity-attributable net income was $81 versus $79, and diluted Class A EPS was $1.54 versus $1.47.
  • Revenue and investment results: Premiums earned rose to $1,215 from $1,109 in Q2 and to $2,390 from $2,196 for the half year. Net realized investment gains were $61 in Q2 versus a $107 loss, and $310 for the half year versus $189. Net investment income declined to $104 from $113 in Q2 and to $207 from $221 for the half year.
  • Underwriting: The Property and Casualty Group’s earned premiums increased 9.4% in Q2 and 8.8% for the half year. Its combined ratio improved to 99.1% from 114.6% in Q2 and to 99.0% from 103.9% for the half year; below 100% generally indicates underwriting profit.
  • Indemnity management operations: Management fee revenue was $336 in Q2, up 9.0%, and $632 for the half year, up 9.6%. Gross margin decreased to 17.3% from 18.6% in Q2 and to 16.7% from 17.8% for the half year.
  • Cash flow and liquidity: Six-month operating cash flow was $330 versus $191; investing used $335 versus $57, and financing used $30 versus $79. Cash and equivalents were $365 at June 30, down from $400 at year-end. Investments totaled $13,102; total assets were $15,879 and total liabilities $8,911.
  • Capital and debt: No borrowings were outstanding on Indemnity’s $100 revolving credit line or the Exchange’s $300 line; both were covenant-compliant. Total equity was $6,968, including $647 attributable to Indemnity shareholders and $6,321 of Exchange noncontrolling interest.
  • Comprehensive income: Q2 comprehensive loss was $20, including $197 of other comprehensive loss, largely reflecting unrealized losses on available-for-sale securities. Six-month comprehensive income was $248.

Material changes versus the prior comparable period

  • Q2 consolidated results swung to profit primarily as P&C underwriting improved and investment results moved from a large realized loss to a gain. Indemnity shareholder net income, however, increased only slightly.
  • Catastrophe losses fell to $45 in Q2 from $204 and to $72 for the half year from $229. Prior-year reserve development was adverse by $18 in Q2 and $25 for the half year, versus favorable development of $5 and $24, respectively, in 2012.
  • Management attributed premium growth to more policies in force and higher average premiums. Direct written premium increased 9.3% in Q2 and 9.7% for the half year.
  • Investment income declined despite higher investment balances at the Exchange, as lower yields more than offset those balances. The large realized-gain increase mainly reflected common-stock sales and fair-value changes.
  • Operating cash flow improved, while investment outflows increased with purchases of fixed maturities and common stocks. Indemnity’s shareholder dividends paid were lower year over year partly because the regular dividend normally paid in January 2013 was accelerated into December 2012; 2013 quarterly dividends per share were increased 7.2%.

Outlook, risks, contingencies, and unusual items

  • No specific earnings or revenue guidance is provided. Management said it expects operating cash needs to be met from operations, believes liquidity is sufficient through 2013, and cites available cash, credit facilities, and investments as funding sources.
  • Key risks include catastrophe severity, claims frequency and severity, reserve estimation, inflation in medical and repair costs, reinsurance availability and collectability, investment-market and interest-rate volatility, and dependence on the Exchange and the independent agency system. Indemnity shareholders have no rights to Exchange assets or credit facilities.
  • Indemnity faces the Sullivan lawsuit alleging approximately $308 million of retained service and other charges and seeking an accounting of intercompany transactions. The Third Circuit affirmed remand to state court; dismissal and stay-related matters remained unresolved. A related Beltz lawsuit names Indemnity directors and asserts similar allegations. The filing reports no established material loss estimate for these cases.
  • An unclaimed-property audit is ongoing, and Erie Family Life was sued by West Virginia over alleged unclaimed-property compliance failures. The company says additional claims payments, escheatment, and possible fines are probable, but it cannot reasonably estimate a loss or range at this stage.
  • The Exchange and Indemnity had $393 million and $30 million, respectively, in remaining limited-partnership investment commitments. Litigation accruals were described as appropriate and not expected to be material, although the filing cautions that a substantial judgment or settlement could have a material adverse effect.
  • Limited-partnership results are generally reported one quarter in arrears. Their reported earnings for the six months ended June 30, 2013 therefore reflect partnership results through the first quarter of 2013, not the second quarter.

Most important facts for investors to verify

  1. Separate consolidated Exchange results from earnings attributable to Indemnity shareholders; the consolidated profit increase did not translate into a comparable increase in Indemnity-attributable income.
  2. Assess how much of reported earnings depends on realized investment gains and whether those gains are repeatable; Q2 and year-to-date gains were substantial.
  3. Track P&C combined ratios, catastrophe losses, current accident-year loss trends, and adverse prior-year reserve development, especially for large injury claims.
  4. Review the outcomes and potential exposure from the Sullivan and Beltz lawsuits and the unclaimed-property audit and West Virginia proceeding; several matters lacked estimable loss ranges.
  5. Monitor investment yields, unrealized portfolio losses, limited-partnership valuation timing and liquidity, and the $423 million of combined remaining partnership commitments.
  6. Confirm that liquidity and covenant compliance remain adequate while recognizing that Exchange assets and credit facilities are not available to Indemnity shareholders.