Erie Indemnity Company — Q3 2018 Form 10-Q
Reporting period: Three and nine months ended September 30, 2018; balance-sheet figures are compared with December 31, 2017. Amounts below are in millions of dollars unless stated otherwise.
Business context
Erie Indemnity acts as attorney-in-fact and management company for Erie Insurance Exchange, its sole customer. It earns fees tied to the Exchange’s written premiums and provides policy issuance and renewal services; administrative-service costs are reimbursed at cost. The Exchange, not Indemnity, conducts the insurance operations.
Financial performance
| Metric | Q3 2018 | Q3 2017 | 9M 2018 | 9M 2017 |
|---|---|---|---|---|
| Total operating revenue | $612.1 | $442.5 | $1,805.7 | $1,290.4 |
| Operating income | $96.7 | $81.2 | $269.6 | $231.6 |
| Income before taxes | $104.5 | $88.9 | $288.7 | $251.1 |
| Income tax expense | $24.0 | $30.3 | $62.8 | $86.1 |
| Net income | $80.4 | $58.5 | $225.9 | $164.9 |
| Diluted Class A EPS | $1.54 | $1.12 | $4.32 | $3.15 |
- Q3 operating income increased 19.0% and net income 37.4%; for the first nine months, operating income rose 16.4% and net income 37.0%.
- Exchange direct and assumed premiums written rose 7.1% to $1.86 billion in Q3 and 6.9% to $5.43 billion year to date. Policy-in-force growth and higher average premiums contributed.
- Policy issuance and renewal costs increased 3.9% in Q3 and 4.2% year to date, mainly from higher commissions as premiums grew. Nine-month operating income for these services was $229.7 million, down 0.8%.
- Net investment income increased to $7.7 million in Q3 and $21.6 million year to date. Total investment income was nearly flat in Q3 and decreased 3.1% year to date, reflecting weaker limited-partnership earnings and realized investment losses.
- The effective corporate tax rate fell to 21% from 35% following the Tax Cuts and Jobs Act, contributing to lower tax expense and higher net income.
- Comprehensive income was $80.0 million in Q3 and $219.4 million year to date. Year-to-date other comprehensive loss was $6.5 million, primarily from unrealized investment losses.
Cash flow, balance sheet and liquidity
- Nine-month operating cash flow was $174.3 million, versus $120.3 million in 2017. Investing cash outflow was $53.0 million; financing cash outflow was $92.4 million. Cash increased $29.0 million to $244.7 million.
- At September 30, total assets were $1.760 billion, total liabilities $838.5 million and shareholders’ equity $921.0 million. Current assets of $888.9 million exceeded current liabilities of $544.5 million.
- Long-term borrowings were $98.3 million and the current portion was $1.4 million. The $100 million term facility was fully drawn; it bears fixed interest of 4.35%, with principal amortization beginning in 2019. Indemnity had no borrowings on its revolving credit line and $99.1 million remained available, subject to facility terms.
- Cash and investments included $704.2 million of available-for-sale securities. A $107.5 million fair-value amount of bonds was pledged as collateral for credit facilities. Management stated liquidity needs were expected to be met from operations and available resources, while noting marketability risks for some investments.
- The company made an $80 million accelerated pension contribution in the first half of 2018, compared with $39 million contributed in the first nine months of 2017. Dividends paid were $117.4 million; declared Class A dividends were $0.84 per share for Q3, up from $0.7825.
Material changes, outlook and risks
- ASC 606 adoption: Effective January 1, 2018, Indemnity allocated management fees between policy services and administrative services. It recognized administrative-service fee revenue over four years and established a $48.5 million opening contract liability, with a $38.3 million reduction to opening retained earnings after tax. Administrative-service reimbursements and matching expenses are now reported gross. This presentation increased reported revenue and expenses but did not affect operating income for the reimbursed costs; prior-year figures were not restated.
- The management fee rate was 25% overall in 2018 and 2017; under the new allocation, the filing reports 24.2% assigned to policy issuance and renewal services and 0.8% to administrative services. Q3 and year-to-date administrative-service reimbursements were $140.2 million and $432.6 million, respectively, with corresponding expenses.
- Management said the Exchange planned to continue premium growth and strengthen its competitive position, including through agency expansion and market penetration. No specific Indemnity earnings or revenue guidance was provided; management cautioned interim results are not necessarily indicative of full-year results.
- Key risks include dependence on the Exchange’s growth, financial strength and agency relationships; catastrophe losses; premium and retention trends; operating costs; investment-market and interest-rate volatility; credit concentration in receivables from the Exchange; technology and cybersecurity; liquidity; and litigation.
- The Exchange and its property-casualty subsidiaries were rated A+ (Superior) with a stable outlook, and reported $9.1 billion of statutory policyholders’ surplus at September 30, 2018. Indemnity’s receivables from the Exchange and affiliates were $463.6 million, a material customer concentration.
- Litigation remains outstanding. The Sullivan lawsuit alleges approximately $308 million of improperly retained service charges; Indemnity sought dismissal, and a motion to enforce a separate federal judgment remained pending. In the Ritz lawsuit, plaintiffs allege excessive management fees; motions to dismiss remained pending. The company says it has meritorious defenses. It also disclosed an $18.1 million contingent pension-related liability if Erie Family Life does not honor certain annuity contracts.
- Limited-partnership investment commitments totaled $13.9 million. The headquarters construction project is expected to cost $100 million and was funded through the term facility; $53.1 million of project costs had been incurred by September 30.
Important facts for investors to verify
- How much of reported revenue growth reflects Exchange premium growth versus ASC 606’s reallocation and gross presentation of reimbursements.
- Whether premium growth, retention and underwriting results continue to support management-fee revenue and agent incentive costs.
- Progress and potential exposure in the Sullivan and Ritz lawsuits, including any developments affecting reserves or disclosures.
- Investment portfolio valuation, realized and impairment losses, and liquidity of pledged or less-liquid assets.
- Term-loan amortization beginning in 2019, pension funding needs, and the remaining costs of headquarters construction.