Erie Indemnity Company — Q2 2017 Form 10-Q
Reporting period: Three and six months ended June 30, 2017, compared with the corresponding 2016 periods. Amounts below are in U.S. dollars; financial figures are generally shown in millions.
Business context
Erie Indemnity is the attorney-in-fact and management company for Erie Insurance Exchange, which writes property and casualty insurance. Indemnity earns a fee based on Exchange direct and assumed premiums; the Exchange is its sole customer. Insurance operations are conducted by the Exchange, not Indemnity.
Financial performance
| Metric | Q2 2017 | Q2 2016 | Six months 2017 | Six months 2016 |
|---|---|---|---|---|
| Operating revenue | $448.6m | $423.9m | $847.9m | $798.6m |
| Operating expenses | $365.5m | $338.1m | $698.3m | $645.2m |
| Operating income | $83.0m | $85.8m | $149.6m | $153.4m |
| Total investment income | $6.4m | $7.4m | $13.0m | $10.0m |
| Net income | $58.5m | $61.3m | $106.4m | $107.2m |
| Diluted Class A EPS | $1.12 | $1.17 | $2.03 | $2.04 |
| Gross operating margin | 18.5% | 20.2% | 17.6% | 19.2% |
Revenue growth was driven by management fees: Exchange premiums written increased 5.7% to $1.77bn in Q2 and 6.2% to $3.35bn for the first half. The management fee rate remained at 25%. Operating expenses grew faster than revenue, principally reflecting commissions and higher information-technology costs, contributing to lower operating income and compressed margins. Q2 total investment income fell 12.9%, mainly due to lower limited-partnership earnings; first-half investment income rose 30.8%, supported by higher net investment income and realized gains. Interest expense was $0.3m in Q2 and $0.4m for the first half, versus none in 2016.
Cash flow, financial position and capital
- Cash flow: First-half operating cash flow was $39.5m, down from $50.5m. Investing used $35.9m and financing used $47.9m; cash decreased $44.4m to $144.7m. Lower operating cash flow reflected higher commission and bonus payments and general operating expenses.
- Liquidity: At June 30, cash was $144.7m and current assets were $671.1m, compared with current liabilities of $431.0m. The $100m revolving facility had no borrowings and $99.1m available, net of letters of credit. Management also cited approximately $356m of unpledged investment-grade bonds as a potential liquidity source, while noting market-liquidity risks.
- Debt: Long-term borrowings were $49.7m carrying value after a second $25m draw under the $100m headquarters term loan. The loan carries a fixed 4.35% rate; principal payments begin in 2019. The company reported compliance with debt covenants.
- Assets and equity: Total assets were $1.57bn and shareholders’ equity was $853.2m. Investments totaled $798.1m, predominantly fixed maturities. Defined-benefit pension liabilities were $220.0m.
- Shareholder returns: First-half dividends paid were $72.9m. 2017 quarterly dividends per share were increased 7.2% from 2016. No shares were repurchased under the public program; $17.8m of authority remained. Separate purchases of 55,935 shares for compensation-plan purposes cost $6.7m in the first half.
Outlook, risks and unusual items
- No specific earnings or revenue guidance was provided. Management said the Exchange intends to pursue premium growth through agency expansion and greater market penetration. Exchange premiums grew alongside higher policies in force and average premiums; retention was 89.6% at June 30.
- The Exchange and its property and casualty subsidiaries were rated A+ “Superior”; A.M. Best affirmed a stable outlook on July 12, 2017. Indemnity’s results remain dependent on the Exchange’s growth, financial condition, ratings and ability to retain policyholders.
- Key risks include customer and premium concentration in the Exchange, unsecured receivables from it ($411.4m at June 30), catastrophe or economic impacts on the Exchange, investment-market volatility and liquidity, rising operating costs, technology or cybersecurity disruption, and litigation.
- The company expects an additional $20m pension contribution in Q3 2017, following a $19m contribution in Q1. Limited-partnership investment commitments totaled $16.3m.
- On July 10, 2017, Indemnity agreed to a guaranteed maximum price for its headquarters project of up to $100m, subject to scope changes; substantial completion is expected in January 2020. The project is funded through the term-loan facility, with further $25m draws scheduled in 2017 and 2018.
- A federal “Beltz II” lawsuit concerning retention of policyholder service charges was dismissed in its entirety on July 17, 2017, after quarter-end. A related state “Sullivan” lawsuit remained pending; plaintiffs had alleged approximately $308m in retained charges. The company says it has meritorious defenses. The filing states litigation accruals are not expected to be material, but outcomes and potential exposure remain uncertain.
- Management identified pension-benefit and investment valuation as significant estimates. It preliminarily expected no material financial-statement impact from adopting the new revenue-recognition standard, while continuing to assess reimbursements for costs incurred for the Exchange.
Important facts for investors to verify
- Whether Exchange premium growth continues to outpace Indemnity’s expense growth and supports a recovery in operating margins.
- The drivers and sustainability of higher technology, administrative, incentive-compensation and pension-related costs.
- Cash conversion, the planned pension contribution, term-loan draws and the headquarters project’s final cost and funding.
- Developments in the pending Sullivan litigation and any appeals or other consequences following the Beltz II dismissal.
- Exposure to the Exchange, including the large receivable balance, and changes in the Exchange’s premium growth, retention and A+ rating.