Erie Indemnity Company — Q1 2016 Form 10-Q
Reporting period: Three months ended March 31, 2016; balance-sheet comparisons are with December 31, 2015. Dollar amounts are in millions unless noted.
Business context
Erie Indemnity acts as attorney-in-fact and management company for the Erie Insurance Exchange, which writes property and casualty insurance. Indemnity’s primary revenue is a management fee tied to Exchange premiums; the Exchange is its sole customer. Indemnity does not conduct the Exchange’s insurance operations.
Financial performance
| Metric | Q1 2016 | Q1 2015 | Change |
|---|---|---|---|
| Total operating revenue | $374.7 | $350.8 | +6.8% |
| Operating expenses | $307.1 | $298.4 | +2.9% |
| Net revenue from operations | $67.7 | $52.4 | +29.1% |
| Gross margin from operations | 18.1% | 14.9% | +3.2 percentage points |
| Total investment income | $2.6 | $6.5 | −60.9% |
| Net income | $45.9 | $38.8 | +18.2% |
| Diluted Class A EPS | $0.87 | $0.74 | +18.4% |
| Operating income, non-GAAP | $46.8 | $39.1 | +19.9% |
Net operating revenue and margin improved as management fees grew while expenses rose more slowly. The 25% management fee rate was unchanged; Exchange direct and assumed premiums increased 7.1% to $1.475 billion. Commissions increased 7.7% to $208.7 million, while non-commission expenses fell 6.1% to $98.3 million, mainly due to lower information technology and administrative costs.
Investment income fell mainly because of higher realized investment losses and limited partnership losses. Net realized investment losses were $1.1 million, impairment losses recognized in earnings were $0.3 million, and limited partnerships recorded a $0.7 million loss versus $2.4 million of earnings a year earlier. Partnership results are generally reported one quarter in arrears, so Q1 2016 partnership earnings reflect Q4 2015 activity.
Financial position, cash flow and liquidity
- At March 31, total assets were $1.341 billion, total liabilities $555.8 million, and shareholders’ equity $784.9 million. Cash and cash equivalents were $105.3 million; investments totaled $701.4 million.
- Operating cash flow was negative $21.8 million, investing cash flow negative $21.8 million, and financing cash flow negative $34.0 million. Cash decreased $77.6 million to $105.3 million. Dividends paid were $34.0 million.
- There were no borrowings on the $100 million revolving credit facility; $99.0 million remained available after letters of credit. The company reported compliance with covenants. Bonds with a fair value of $109.4 million were pledged as collateral.
- The filing says operating cash needs are expected to be met from operations and that liquidity is sufficient even if market volatility persists through 2016. It identifies cash, the credit facility, and liquid investment-grade assets as additional funding sources.
- There is no debt balance reported. A $25 million surplus note receivable from Erie Family Life is payable on demand on or after December 31, 2018, subject to insurance regulator approval for principal or interest payments.
Material developments, outlook and risks
- Exchange premiums rose 7.1%; policies in force grew 3.6%, average premium per policy increased 3.4%, and policy retention was 89.9%. Management said the Exchange plans to continue premium growth and improve its competitive position. No specific company earnings or revenue guidance was provided.
- Exchange retention remained high and its property and casualty entities were rated A+ “Superior” by A.M. Best, with a stable outlook reported as of December 31, 2015. The Exchange’s statutory policyholders’ surplus was $7.2 billion at March 31, 2016.
- Effective December 31, 2015, amended consolidation guidance meant the Exchange’s results were no longer consolidated with Indemnity’s. Management reported no resulting change to Indemnity net income or equity.
- Key exposures include dependence on the Exchange’s growth, financial condition and ratings; the concentration of unsecured receivables from the Exchange ($352.5 million); investment-market volatility and limited liquidity in some holdings; and catastrophe, economic, regulatory and litigation risks.
- A Pennsylvania lawsuit alleges Indemnity retained approximately $308 million in service charges that should have gone to the Exchange. The Commonwealth Court vacated an insurance department ruling in January 2016; Indemnity petitioned the Pennsylvania Supreme Court for review and was awaiting action at quarter-end. Indemnity says it has meritorious defenses. The filing does not provide a clear estimated loss or accrual for this claim; management says legal accruals are not expected to be material, while noting that outcomes could be adverse.
- A separate related federal action against directors remains part of the disclosed litigation. A contingent $22.2 million liability exists if Erie Family Life does not honor certain pension annuity contracts.
- Limited partnership funding commitments were $19.1 million. The company had $17.8 million of remaining stock repurchase authorization and made no repurchases during the quarter. Quarterly dividends per share increased 7.2% for 2016 compared with 2015.
Important facts for investors to verify
- Whether premium growth, retention and fee revenue continue, given Indemnity’s reliance on the Exchange and the unchanged 25% management fee rate.
- The outcome and potential financial exposure of the Sullivan and related Beltz litigation, including developments in the Pennsylvania Supreme Court.
- Cash generation and dividend sustainability, considering negative operating cash flow and the quarter’s $77.6 million cash decline.
- Investment portfolio valuations, credit quality and liquidity, including the impact of realized losses and lagged limited partnership reporting.
- Funding and status of the pension plans, the contingent annuity exposure, and the $19.1 million limited partnership commitments.