Erie Indemnity Company — Q3 2012 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2012. Amounts are in millions of dollars except per-share data. The consolidated statements include the Erie Insurance Exchange, whose insurance assets and liabilities belong to Exchange subscribers; Indemnity shareholders do not have rights to Exchange assets or earnings. Accordingly, consolidated results should be distinguished from amounts attributable to Indemnity shareholders.
Business context and financial results
Indemnity acts as attorney-in-fact for the Exchange, providing sales, underwriting and policy-issuance services and earning a management fee set at 25% of qualifying premiums written. The Exchange and its affiliates conduct the property and casualty and life insurance businesses.
| Metric | Q3 2012 | Q3 2011 | Nine months 2012 | Nine months 2011 |
|---|---|---|---|---|
| Total revenue | $1,460 | $796 | $4,140 | $3,406 |
| Premiums earned | $1,137 | $1,061 | $3,333 | $3,138 |
| Net investment income | $105 | $108 | $326 | $326 |
| Net realized investment gains (losses) | $169 | $(422) | $358 | $(234) |
| Income (loss) before tax and noncontrolling interest | $270 | $(305) | $734 | $(67) |
| Consolidated net income (loss) | $184 | $(180) | $500 | $(13) |
| Net income attributable to Indemnity | $51 | $47 | $130 | $143 |
| Indemnity diluted Class A EPS | $0.96 | $0.87 | $2.43 | $2.59 |
Indemnity’s non-GAAP operating income, which excludes realized investment gains and losses, impairments and related taxes, was $50 million in Q3 2012 versus $51 million a year earlier, and $128 million for nine months versus $142 million. Diluted operating income per Class A share was $0.93 in both third quarters and $2.38 versus $2.57 for the nine-month periods.
Underwriting, margins and material period changes
- Property and casualty direct written premiums rose 8.6% in Q3 and 8.0% year to date, driven by growth in policies in force and average premium per policy. Earned premiums increased 7.0% and 6.1%, respectively.
- The P&C combined ratio was 108.9% in Q3 2012 versus 107.7% in Q3 2011, indicating an underwriting loss in both periods. For the first nine months it improved to 105.6% from 114.5%, but remained above 100%.
- Year-to-date catastrophe losses fell to $343 million from $777 million. Favorable prior-year reserve development also declined substantially, to $42 million from $216 million; management cited less favorable prior-year development in 2012.
- Indemnity management-operations revenue rose 8.3% in Q3 and 7.6% year to date, while costs rose 9.5% and 10.1%. Gross margin consequently declined to 20.9% from 21.7% in Q3 and to 18.8% from 20.7% year to date.
- Investment results drove the large consolidated earnings swing: Q3 2012 included $169 million of realized gains, mainly common-stock valuation gains, compared with $422 million of losses in Q3 2011. The nine-month comparison similarly moved from $234 million of losses to $358 million of gains. Limited-partnership earnings fell to $99 million from $150 million year to date; those results are generally reported on a one-quarter lag.
Financial position, cash flow and liquidity
- At September 30, 2012, total assets were $15,544 million, including $12,791 million of investments and $404 million of cash and cash equivalents. At December 31, 2011, the corresponding amounts were $14,348 million, $12,074 million and $185 million.
- Total liabilities were $8,701 million versus $8,055 million. Indemnity shareholders’ equity was $782 million, nearly unchanged from $781 million; Exchange noncontrolling interest rose to $6,061 million from $5,512 million.
- For the first nine months, consolidated operating cash flow was $365 million versus $225 million; investing cash use was $34 million versus $395 million; financing cash use was $112 million versus $184 million. Cash increased by $219 million, compared with a $354 million decrease in 2011.
- No borrowings were outstanding under Indemnity’s $100 million revolving credit facility or the Exchange’s $300 million facility. Both were in covenant compliance. The facilities and the respective entities’ assets are not interchangeable: Indemnity has no rights to the Exchange’s assets, capital or credit line.
- Remaining limited-partnership investment commitments totaled $374 million: $36 million for Indemnity and $338 million for the Exchange. Securities valued using Level 3 unobservable inputs were $112 million, less than 0.9% of the investment portfolio.
Outlook, risks, contingencies and unusual items
- No specific earnings or revenue guidance is provided. Management expects operating cash needs to be met from operations and stated it believes funding sources are available for 2012. It plans to pursue premium growth through its independent-agent network while maintaining underwriting discipline.
- Management identified economic weakness, competition, interest-rate and market volatility, investment liquidity, reserve estimation, catastrophe losses, reinsurance collectability, regulation, and dependence on the Exchange and agency system among the risks to results. Loss and life-policy reserves, investment valuations and other estimates may differ from eventual outcomes.
- Hurricane Sandy occurred after the quarter-end. The company said P&C operations would likely incur losses but could not reasonably estimate them at the filing date; the underwriting impact accrues to Exchange subscribers.
- A lawsuit alleges Indemnity improperly retained service and added service charges and breached duties in transactions with the Exchange. An original complaint alleged approximately $308 million in charges retained over 1998–2011; the amended complaint seeks, among other relief, damages exceeding $50,000 and an accounting. The case was remanded to Pennsylvania state court, and Indemnity’s appeal and request to stay proceedings were pending as of October 29, 2012. Indemnity intends to defend the claims.
- A $6 million reimbursement from the North Carolina Reinsurance Facility reduced Indemnity commission expense in Q2 2012 for prior-period commissions. Management said earlier-period Indemnity commission expense would have been lower by $0.5 million in 2011 and $0.7 million in 2010 had the item been recorded correctly.
- Indemnity continued share repurchases; $84 million of authority remained at September 30. Dividends paid totaled $80 million for the first nine months, and 2012 quarterly dividends per share were increased 7.3% from 2011.
Important facts for investors to verify
- Separate Indemnity shareholder earnings and cash resources from the much larger Exchange subscriber interest when assessing consolidated totals.
- Assess the repeatability of the unusually large investment gains and the effect of common-stock valuation changes on reported earnings.
- Track P&C combined ratios, catastrophe experience, reserve development and the adequacy of loss reserves; the year-to-date underwriting result remained unprofitable.
- Monitor Hurricane Sandy claims, the service-charge litigation and the funding schedule for $374 million of limited-partnership commitments.
- Review management-operation cost growth, declining gross margins, investment income trends and limited-partnership results, including the reporting lag.