ERIE

Business Context and Reporting Period

Company: Erie Indemnity Company
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: June 30, 2009
Business Overview: Erie Indemnity serves as the attorney-in-fact for the Erie Insurance Exchange and operates three reportable segments: Management Operations, Insurance Underwriting Operations, and Investment Operations. The company manages the Exchange's property and casualty insurance business and holds a 5.5% participation in the underwriting results of the Property and Casualty Group.

Key Financial Metrics

Segment Performance (Six Months Ended June 30, 2009):

• Management Operations: Net income of $75.2 million (up 10.0% YoY).
• Insurance Underwriting: Net loss of $2.9 million (compared to $5.0 million income in 2008).
• Investment Operations: Net loss of $28.8 million (compared to $2.4 million income in 2008).

Material Changes vs. Prior Period

• Net Income Decline: Net income for the six months ended June 30, 2009, decreased 38.5% to $43.9 million from $71.3 million in the prior year. This was primarily driven by significant losses in investment operations.
• Investment Losses: Equity in losses from limited partnerships totaled $54.8 million for the six months ended June 30, 2009, compared to earnings of $19.3 million in the same period in 2008. This reflects market volatility in financial and real estate sectors.
• Impairment Charges: Net impairment losses recognized in earnings were $7.2 million for the six months ended June 30, 2009, a significant improvement from $24.4 million in the prior year, aided by the adoption of FSP FAS 115-2.
• Underwriting Results: The GAAP combined ratio for insurance underwriting operations increased to 103.9% for the six months ended June 30, 2009, from 92.9% in 2008. This deterioration was due to higher catastrophe losses ($4.8 million vs. $2.4 million) and adverse development of prior accident year loss reserves.
• Management Operations: Revenue grew 1.2% year-over-year, driven by a 0.9% increase in direct written premiums from the Property and Casualty Group. Gross margins improved to 20.8% from 19.1%.

Guidance, Outlook, Risks, and Unusual Items

• Accounting Changes: The company adopted FSP FAS 115-2 in the second quarter of 2009, changing the presentation of other-than-temporary impairments (OTTI). This resulted in a cumulative effect adjustment increasing retained earnings by $6.7 million. Additionally, FAS 167 is expected to require the consolidation of the Erie Insurance Exchange starting in the first quarter of 2010.
• Unusual Items: An adjustment of $5.0 million was recorded in Q2 2009 to correct a misinterpretation of facts regarding Q1 2009 equity in losses of limited partnerships. This reduced Q2 net income by $5.0 million.
• Outlook: Management expects pricing actions to result in a net increase in direct written premiums in 2009, though economic conditions may suppress average premiums. Pension expenses are expected to increase by approximately $10 million in 2009 due to a lower discount rate assumption (6.06% vs. 6.62%).
• Risks:
  • Market Volatility: Continued instability in financial markets poses risks to the valuation of fixed income, preferred stock, and limited partnership investments.
  • Exchange Dependence: The company's management fee revenue (85% of total revenue) is tied to the financial health of the Erie Insurance Exchange. A decline in the Exchange's surplus could reduce management fees.
  • Catastrophes: Exposure to natural disasters (wind, hail, flooding) continues to impact underwriting results.

Investor Verification Checklist

• Limited Partnership Lag: Verify the impact of the one-quarter reporting lag on limited partnership valuations, as Q2 2009 results reflect Q4 2008 and Q1 2009 market conditions which may not fully capture Q2 2009 volatility.
• Consolidation of Exchange: Monitor the implementation of FAS 167 and the subsequent consolidation of the Erie Insurance Exchange, which will significantly alter the reporting entity and financial presentation starting Q1 2010.
• Impairment Methodology: Review the application of FSP FAS 115-2 regarding the separation of credit-related losses from non-credit impairments in the investment portfolio.
• Underwriting Reserves: Assess the adequacy of loss reserves given the adverse development of prior accident years and increased catastrophe losses in the first half of 2009.
• Liquidity Position: Confirm the company's ability to meet funding requirements given the decline in cash equivalents ($61.1M to $26.4M) and the illiquid nature of limited partnership investments.