Business context and reporting period
Erie Indemnity Company’s Form 10-K covers the fiscal year ended December 31, 2018. The company serves as attorney-in-fact for policyholders of Erie Insurance Exchange (the Exchange), its sole customer, providing policy issuance and renewal as well as claims, investment and other administrative services. Its main earnings driver is a management fee tied to the Exchange’s premiums written.
Financial and operating highlights
| Metric | 2018 | 2017 |
|---|---|---|
| Operating revenue | $2.382 billion | $1.692 billion |
| Operating expenses | $2.038 billion | $1.402 billion |
| Operating income | $344.3 million | $290.3 million |
| Income before taxes | $371.3 million | $315.7 million |
| Net income | $288.2 million | $197.0 million |
| Diluted Class A EPS | $5.51 | $3.76 |
| Operating cash flow | $263.6 million | $197.1 million |
| Total assets / shareholders’ equity | $1.778 billion / $973.7 million | $1.666 billion / $857.3 million |
Exchange direct and assumed written premiums rose 6.9% to $7.113 billion. Policy issuance and renewal operating income was $290.7 million, up 0.2%; administrative-services management fee revenue was $53.6 million. The additional $580.3 million of administrative-services reimbursement revenue was matched by the same amount of expense and had no net operating-income impact.
Total investment income declined 9.8% to $25.8 million, including $2.0 million of realized investment losses and $0.8 million of limited-partnership losses. Net investment income increased to $30.2 million. Year-end cash and equivalents were $266.4 million. Long-term borrowings were $99.7 million; the $100 million revolving credit facility had no borrowings (with $99.1 million available after letters of credit). The company paid $156.5 million in dividends. It contributed $80 million to its pension plan during the year.
Fourth-quarter results
Fourth-quarter 2018 operating revenue was $576.5 million, expenses were $501.7 million, and net income was $62.3 million; diluted Class A EPS was $1.19. Fourth-quarter 2017 net income was $32.1 million and diluted EPS was $0.61. The 2018 quarter also included a $3.4 million gain on the sale of three field offices to the Exchange. Revenue comparisons are affected by the accounting presentation change described below.
Changes versus the prior comparable period
Operating income increased 18.6% and net income increased 46.3% year over year. The lower federal corporate tax rate, reduced from 35% to 21% effective in 2018, contributed materially to the net-income increase; income-tax expense fell by $35.6 million. Exchange premiums written grew alongside increases in policies in force and average premium per policy.
Adoption of ASC 606 on January 1, 2018 changed revenue allocation and presentation: management fees are allocated between policy issuance/renewal and administrative services, and administrative-service reimbursements and their costs are reported gross. This added $580.3 million to both reported revenue and expenses, limiting direct comparability with 2017. Adoption also reduced opening retained earnings by $38.3 million and established a $48.5 million contract liability. The policy issuance/renewal fee allocation was 24.2% of premiums in 2018; the administrative-services allocation was 0.8%. The total management fee rate remained 25%.
Outlook, risks and unusual items
- The Board set the 2019 management fee rate at 25%, its contractual maximum. Management expects Exchange pricing actions to result in a net increase in direct written premiums in 2019, while noting that coverage reductions and business-mix changes could affect results.
- Management said operating cash needs are expected to be met from operations and that liquidity should be sufficient through 2019, including cash, available credit and investments. The new headquarters building is expected to be completed in the first half of 2020; the $100 million term loan carries a fixed 4.35% rate and began amortizing in January 2019.
- Key risks include dependence on the Exchange and its premium growth, competition and independent-agent relationships, catastrophe losses, investment-market and liquidity risk, cyber and technology disruptions, rising employee costs, and regulatory or legal exposure. Receivables from the Exchange and affiliates were $449.9 million, about 25% of total assets.
- The Exchange and its property-casualty subsidiaries held A.M. Best A+ (“Superior”) ratings with a stable outlook in 2018. Erie Indemnity’s municipal-bond portfolio was being rebalanced into short-term U.S. Treasuries; remaining municipal bonds were expected to be sold in the first half of 2019. Limited-partnership results are generally reported one quarter late and therefore do not reflect fourth-quarter 2018 market conditions.
- Policyholder allegations over service charges and management fees remain a notable contingency. The Beltz II case was dismissed and affirmed on appeal; the related Sullivan state-court matter remained pending at filing. The Ritz lawsuit was dismissed with prejudice on February 4, 2019. The company stated that accrued legal contingencies were not expected to be material, while noting that some potential losses cannot be reasonably estimated.
- The company reported no material off-balance-sheet obligations. Independent auditors gave unqualified opinions on the financial statements and internal control over financial reporting.
Important facts for investors to verify
- Separate underlying operating performance from ASC 606’s gross presentation of administrative reimbursements and costs when comparing revenue and expense trends.
- Track Exchange written-premium growth, policy retention, pricing adequacy and the effect of the maximum management fee rate on Indemnity’s earnings.
- Assess the concentration and collection risk of the $449.9 million Exchange-related receivable, alongside Exchange financial strength and ratings.
- Monitor investment results, credit quality, the municipal-bond portfolio transition and the reporting lag on limited partnerships.
- Review debt amortization, headquarters construction costs, pension funding and dividend commitments against available liquidity.
- Follow developments in the Sullivan litigation and any subsequent legal or regulatory disclosures.