Erie Indemnity Company — FY2017 Form 10-K
Reporting period: Fiscal year ended December 31, 2017; the filing also reports fourth-quarter results. Amounts are in U.S. dollars.
Business context
Erie Indemnity is the management company and attorney-in-fact for Erie Insurance Exchange; it does not conduct the Exchange’s insurance underwriting operations. The Exchange is its sole customer. Indemnity’s primary revenue is a management fee based on the Exchange’s direct and assumed premiums written. The fee rate was 25% in 2017 and 2016, the contractual maximum, and was set at 25% for 2018. The Exchange’s 2017 written premiums were 71% personal lines and 29% commercial lines.
Financial performance and position
- Revenue: Operating revenue was $1.692 billion, up 6.0% from $1.597 billion. Net management fee revenue was $1.663 billion, up 6.1%; service agreement revenue was $29.1 million.
- Expenses and margins: Operating expenses rose 7.6% to $1.403 billion, exceeding revenue growth. Operating income fell 1.4% to $288.4 million. Operating margin was 17.0%, versus 18.3% in 2016.
- Profit and EPS: Income before taxes was $315.7 million, down 1.4%; net income was $197.0 million, down 6.4% from $210.4 million. Diluted Class A EPS was $3.76, down 6.2% from $4.01. The 2017 results include a $10.1 million tax expense related to tax reform.
- Investment income: Total investment income increased 2.6% to $28.6 million. Net investment income rose 19.8% to $24.6 million, while limited partnership earnings declined 60.1% to $2.8 million.
- Cash flow: Operating cash flow was $197.1 million, down from $254.3 million. Investing activities used $74.7 million and financing activities used $95.8 million. Cash and cash equivalents ended the year at $215.7 million.
- Balance sheet and liquidity: Total assets were $1.666 billion and shareholders’ equity was $857.3 million. Receivables from the Exchange and affiliates were $418.3 million, about 25% of total assets. The company reported $74.7 million of long-term borrowings, with $75 million drawn under its $100 million construction term facility. Its separate $100 million revolving credit line had no borrowings and $99.1 million available, subject to letters of credit.
- Capital returns: Dividends declared per Class A share increased to $3.1875 from $2.9725. The company reported a 7.3% dividend increase approved for 2018. No shares were repurchased under the public repurchase program in 2017; approximately $17.8 million of authority remained.
Changes versus 2016 and fourth quarter
- Exchange premiums written increased 6.0% to $6.657 billion. Policies in force grew 3.5%, and average premium per policy rose 2.4%. New-business premiums increased 12.3% to $846 million.
- Higher commissions, personnel costs, and information-technology expenses drove the 7.6% increase in operating expenses. Information-technology costs rose 15.8%.
- For Q4 2017, operating revenue was $401.4 million versus $379.6 million in Q4 2016; net income was $32.1 million versus $45.8 million. Q4 2017 diluted Class A EPS was $0.61 versus $0.87. The filing attributes a $0.19 reduction in full-year diluted EPS to the tax-reform charge.
- The enacted Tax Cuts and Jobs Act reduced the federal corporate tax rate from 35% to 21% effective January 1, 2018. The company remeasured deferred taxes and reported a net deferred tax asset of $19.4 million, down from $53.9 million.
Outlook, risks and contingencies
- Management expects operating cash needs to be met from operations and stated that liquidity should be sufficient through 2018. It expects the effective corporate tax rate to decline to approximately 21% beginning in 2018.
- The Exchange expects its pricing actions to produce a net increase in direct written premiums in 2018, though coverage reductions or business-mix changes could affect average premiums. Indemnity’s management fee rate for 2018 remains 25%.
- The company expects an $80 million accelerated pension contribution in 2018: $40 million was contributed in January, with another $40 million planned for April. The defined benefit pension liability was $207.5 million at year-end.
- Construction of a new headquarters building is expected to reach substantial completion in January 2020. The project has a $100 million expected cost and is funded by the term loan facility; $26.3 million of project costs had been incurred by year-end.
- Key risks include dependence on the Exchange and its premium growth, the Board’s authority to change the management fee rate, competition and agency relationships, catastrophe losses, insurance regulation, investment-market and liquidity risks, pension assumptions, technology and cybersecurity risks, and the concentration of unsecured affiliate receivables.
- Material litigation includes the Sullivan action, which alleges improper retention of installment and other service charges; related appeals and proceedings remain relevant. A separate federal action concerning those charges was dismissed in July 2017 and appealed. A new federal Ritz lawsuit filed in December 2017 alleges excessive management fees. The company says it will vigorously defend these matters; it states that litigation accruals are not expected to be material, but some potential losses cannot be reasonably estimated.
- Management reported effective disclosure controls and internal control over financial reporting. The auditor issued unqualified opinions on the financial statements and internal controls.
Important facts for investors to verify
- Whether Exchange premium growth, retention, and pricing actions continue to support management fee revenue—and whether the fee rate remains at the maximum 25%.
- Whether expense growth, particularly commissions, employee benefits, and technology spending, moderates enough to restore operating margin.
- The status, potential exposure, and any subsequent developments in the Sullivan, Beltz II, and Ritz litigation; the filing does not provide a clear estimate of possible losses for certain proceedings.
- Collection and credit quality of the $418.3 million affiliate receivable concentration, along with the Exchange’s financial strength and A.M. Best A+ rating.
- Execution and total cost of the headquarters project, term-loan amortization, and the planned 2018 pension contributions.
- Effects of tax reform and the adoption of new revenue-recognition guidance in 2018; management expected no material effect from the revenue guidance on financial condition, earnings, EPS, or cash flows.