Erie Indemnity Company — Q2 2016 Form 10-Q
Reporting period: Three and six months ended June 30, 2016; unaudited. Erie Indemnity acts as attorney-in-fact and management company for Erie Insurance Exchange, which writes property and casualty insurance. Indemnity’s revenue and results depend heavily on Exchange premiums; it does not itself conduct the insurance operations.
Financial performance
| Metric | Q2 2016 | Q2 2015 | Six months 2016 | Six months 2015 |
|---|---|---|---|---|
| Operating revenue | $423.9 million | $401.7 million | $798.6 million | $752.5 million |
| Net revenue from operations | $85.8 million | $70.0 million | $153.4 million | $122.4 million |
| Net income | $61.3 million | $56.2 million | $107.2 million | $95.0 million |
| Diluted Class A EPS | $1.17 | $1.07 | $2.04 | $1.81 |
| Total investment income | $7.4 million | $15.7 million | $10.0 million | $22.2 million |
- Operating revenue increased 5.5% in Q2 and 6.1% year to date; net income rose 9.2% and 12.9%, respectively. Net revenue from operations increased 22.5% and 25.3%.
- Operating gross margin improved to 20.2% from 17.4% in Q2 and to 19.2% from 16.3% year to date. Management attributed the improvement to revenue growth exceeding expense growth.
- Management fee revenue, net, rose 5.7% in Q2 and 6.3% year to date. Exchange direct and assumed premiums written rose 5.8% to $1.68 billion in Q2 and 6.4% to $3.15 billion year to date; the fee rate remained 25%.
- Operating expenses increased 1.9% in Q2 and 2.4% year to date. Higher commissions, reflecting premium growth and agent incentives, were partly offset by lower non-commission expenses, particularly information technology costs.
- Investment income fell 52.9% in Q2 and 55.2% year to date, primarily because limited partnership earnings were much lower. Year-to-date limited partnership earnings were $1.4 million versus $13.1 million; the reported results generally lag underlying partnership activity by one quarter. Net investment income itself increased 10.3% in Q2 and 6.4% year to date.
- Six-month operating cash flow was $50.5 million versus $41.9 million. Investing activities used $41.3 million, compared with providing $6.4 million in the prior year; dividends used $68.0 million. Cash and cash equivalents declined $58.8 million to $124.1 million.
Financial position and liquidity
- At June 30, 2016, total assets were $1.415 billion, total liabilities $599.6 million, and shareholders’ equity $815.2 million. Available-for-sale securities were $653.6 million; total investments, including limited partnerships and trading securities, were approximately $725 million.
- Indemnity had no borrowings under its $100 million revolving credit facility; $99 million remained available after letters of credit. The facility expires November 2020, and the company reported compliance with its covenants. It pledged bonds with a fair value of $111.1 million as collateral.
- The company said operating cash needs are expected to be met from operations and that it believes liquidity is sufficient, including if market volatility persists through 2016. Other potential sources include cash, the credit line, and investment portfolio assets. There is no quantified earnings guidance.
- Dividends paid were $68.0 million in the first half. Regular quarterly dividends per share increased 7.2% for 2016 versus 2015. No repurchases were made under the public program; approximately $17.8 million of authorization remained.
Material changes, outlook and risks
- The Exchange’s premiums grew through increases in policies in force and average premium per policy. Management reported policy retention of 89.8% at June 30, 2016 and an A.M. Best financial strength rating of A+ (“Superior”) with a stable outlook. The Exchange is Indemnity’s sole customer.
- Management described continued efforts by the Exchange to grow premiums, expand its agency force, and improve competitive position. New-business premium growth slowed to 2.6% in Q2, while renewal premiums increased 6.2%.
- Effective December 31, 2015, revised consolidation guidance resulted in the Exchange no longer being consolidated. The filing says this caused no change to Indemnity’s net income or equity.
- Credit concentration is significant: $387.3 million of management-fee and other affiliate receivables was due at June 30, up from $348.1 million at year-end. The company identifies dependence on the Exchange, its growth and financial condition, severe weather and catastrophe losses, investment-market volatility, liquidity, employee retention, and litigation as risks.
- A Pennsylvania lawsuit alleges Indemnity improperly retained installment and other service charges, with plaintiffs citing approximately $308 million and seeking monetary and other relief. A related new federal action was filed July 8, 2016. Indemnity disputes the allegations and intends to defend; the Pennsylvania Supreme Court had not yet acted on Indemnity’s appeal petition. The filing says litigation accruals are not expected to be material overall, but notes some legal losses cannot be reasonably estimated at this stage.
- Other items: limited partnership investment commitments were $18.9 million; the company disclosed a contingent $21.8 million liability if Erie Family Life does not honor certain pension annuity contracts. No material off-balance-sheet obligations were reported apart from partnership commitments.
Important facts for investors to verify
- Whether Exchange premium growth, policy retention, and the 25% management-fee rate remain supportive of Indemnity’s revenue and operating margins.
- How limited partnership performance develops, including the effect of the one-quarter reporting lag and the large year-over-year decline in partnership earnings.
- Progress and potential exposure in the Sullivan and new Beltz litigation, including whether any loss becomes probable and estimable.
- Collection and credit quality of the $387.3 million affiliate receivable, given Indemnity’s customer concentration.
- Cash generation, dividend commitments, pension funding, investment liquidity, and use of the credit facility as market conditions change.