Business context and reporting period
Erie Indemnity Company’s unaudited Form 10-Q covers the quarter and six months ended June 30, 2020. The company acts as attorney-in-fact and service provider to the Erie Insurance Exchange, its sole customer. Its primary earnings source is a management fee based on Exchange premiums; administrative-service costs are generally reimbursed at cost.
Financial results
| Metric | Q2 2020 | Q2 2019 | Six months 2020 | Six months 2019 |
|---|---|---|---|---|
| Operating revenue | $657.0m | $647.7m | $1,273.8m | $1,241.8m |
| Operating income | $91.2m | $96.6m | $176.9m | $182.7m |
| Total investment income | $11.6m | $9.7m | $2.4m | $19.4m |
| Net income | $82.0m | $87.8m | $141.3m | $163.1m |
| Class A diluted EPS | $1.57 | $1.68 | $2.70 | $3.12 |
Operating margin, calculated as operating income divided by reported operating revenue, was approximately 13.9% in Q2 2020 versus 14.9% a year earlier; for the six-month periods it was 13.9% versus 14.7%. Administrative-service reimbursements and matching expenses are reported gross, with no operating-income effect.
- Cash flow: Six-month operating cash flow was $127.3m, compared with $114.4m in 2019. Investing activities used $115.4m, versus $42.2m provided in 2019; financing activities used $90.9m. Cash and equivalents fell $79.0m to $257.7m.
- Balance sheet and liquidity: Total assets were $2.08bn and shareholders’ equity $1.19bn at June 30. Reported borrowings were approximately $96.8m. No revolving-line borrowings were outstanding; $99.1m of the $100m facility remained available, subject to letters of credit. The company reported compliance with covenants.
- Dividends: Six-month cash dividends paid were $89.9m. The quarterly Class A dividend declared was $0.965 per share, up from $0.90 in 2019.
Material changes versus prior periods
- Q2 revenue rose 1.4%, but operating income fell 5.6% and net income fell 6.6%; operating expenses grew faster than revenue. Six-month revenue rose 2.6%, while operating income declined 3.2% and net income declined 13.3%.
- Exchange premiums written increased 0.5% in Q2 to $2.0bn and 1.9% for six months to $3.9bn. New-business premiums fell 18.6% in Q2, reflecting pandemic-related disruptions and weaker economic conditions.
- Policy issuance and renewal costs rose 2.2% in Q2 and 3.0% for six months, driven partly by higher agent incentives as claims frequency declined, as well as technology and other costs.
- Investment results were volatile: Q2 investment income increased year over year, including $6.5m of net realized gains, while six-month investment income fell sharply, including $4.3m of net realized losses, $3.1m of impairment losses, and $6.0m of limited-partnership losses.
Outlook, risks and unusual items
- The Exchange’s announced auto rate reductions, effective from July 1, 2020 as policies renew or begin, were expected to reduce its 2020 premiums by about $90m and Indemnity’s 2020 management-fee revenue by an estimated $23m; further effects were expected in 2021. Management gave no broader numerical earnings guidance.
- Management said pandemic duration and financial impact remain uncertain. Risks include constrained premium growth, cancellations or nonrenewals, agent and operating costs, investment-market volatility, collectability of Exchange receivables, and cyber or business-continuity issues. More than 90% of employees were working remotely, with no significant disruption reported through the filing.
- Indemnity reported $506.7m in net receivables from the Exchange and affiliates, creating customer concentration and unsecured credit exposure. The Exchange’s A+ financial-strength rating had a stable outlook as of July 8, 2020.
- COVID-19-related cancellation assumptions increased the allowance against management fees by a cumulative $4.4m in the first half. Adoption of the new credit-loss standard resulted in a $1.1m after-tax opening retained-earnings adjustment; management said adoption did not materially affect the financial statements.
- A lawsuit alleges approximately $308m in improperly retained service charges. The related Beltz II federal case was dismissed and affirmed on appeal; the separate Sullivan state case remained pending. The company said its legal accruals were appropriate and litigation was not expected to be material, while noting outcomes cannot be assured.
Important facts for investors to verify
- Whether Exchange premium growth, new-business trends, and the announced rate reductions develop as management estimated.
- Whether reduced claims frequency and higher agent-incentive costs persist, and how they affect operating margins.
- Subsequent investment gains or losses, credit impairments, and the liquidity or valuation of portfolio holdings.
- Collectability of the substantial Exchange-related receivable and the continuing concentration in a single customer.
- Developments in the Sullivan litigation and any change in the company’s assessment of potential exposure.