Erie Indemnity Company — 2015 Form 10-K
Reporting period: Fiscal year ended December 31, 2015; the filing also reports unaudited fourth-quarter results. Financial statement amounts below are in U.S. dollars; annual and quarterly figures are identified where relevant.
Business context
Erie Indemnity is the management company and attorney-in-fact for Erie Insurance Exchange, its sole customer. The Exchange conducts the insurance business; Indemnity provides sales, underwriting, policy-issuance and related services, earning a fee based primarily on the Exchange’s direct and assumed premiums. The fee rate was 25% in 2015 and was set at 25% for 2016. Exchange premiums were approximately 70% personal lines and 30% commercial lines.
Financial performance and position
| Metric | 2015 | 2014 | Change |
|---|---|---|---|
| Operating revenue | $1,505.5 million | $1,407.1 million | +7.0% |
| Operating expenses | $1,273.0 million | $1,184.3 million | +7.5% |
| Net revenue from operations | $232.5 million | $222.8 million | +4.3% |
| Gross margin from operations | 15.4% | 15.8% | Down 0.4 percentage points |
| Total investment income | $33.7 million | $28.4 million | +18.6% |
| Income before income taxes | $266.2 million | $251.3 million | +6.0% |
| Net income | $174.7 million | $167.5 million | +4.3% |
| Diluted Class A earnings per share | $3.33 | $3.18 | +4.5% |
| Operating cash flow | $217.4 million | $186.0 million | Increased |
Revenue growth reflected a 7.3% increase in Exchange direct and assumed premiums written, to $5.914 billion. Indemnity’s net management fee revenue was $1,475.5 million; service agreement revenue was $30.0 million. Commissions, the largest expense category, increased 8.3% to $847.9 million, principally with premium growth and higher agent incentives. Personnel and other operating costs also increased.
Investment income rose mainly because of higher limited-partnership earnings, which increased to $17.0 million from $10.9 million. Net investment income was $17.8 million; impairment losses recognized in earnings were $1.6 million, versus $0.1 million in 2014. Limited-partnership results are generally reported on a one-quarter lag, so most reported 2015 partnership results did not reflect fourth-quarter 2015 market conditions.
Fourth quarter: Operating revenue was $356.4 million versus $337.3 million in 2014; operating expenses were $314.5 million versus $301.8 million. Net income was $30.1 million versus $25.3 million, and investment income was $4.2 million versus $2.3 million.
At year-end, total assets were $1,407.3 million, shareholders’ equity was $769.5 million, cash and cash equivalents were $182.9 million, and investments were approximately $688.8 million. Receivables from the Exchange and affiliates were $348.1 million, or 24.7% of total assets. Indemnity had no borrowings on its $100 million revolving credit facility; $98.2 million remained available after letters of credit.
Dividends declared per Class A share totaled $2.773 for 2015, up from $2.586. Dividends paid were $126.9 million. No shares were repurchased under the public repurchase program during 2015; approximately $17.8 million of authorization remained.
Material changes and accounting
- Exchange premiums written rose 7.3%; policies in force increased 3.6%, while average premium per policy increased 3.5%. New-business premiums rose 3.9% and renewal premiums rose 7.7%.
- Personal-lines premiums increased 6.5% and commercial-lines premiums increased 9.1%. The Exchange’s policy-retention ratio was 89.9%, compared with 90.3% in 2014.
- Operating expenses grew faster than operating revenue, and the operating gross margin declined to 15.4% from 15.8%.
- Effective retrospectively for 2015, adoption of the revised consolidation standard meant Indemnity no longer consolidated the Exchange. The filing restates the 2014 and 2013 comparative presentation; the change did not create a cumulative effect on Indemnity shareholders’ equity. Consider this presentation change when comparing the filing with earlier reports.
- Investments totaled $688.8 million, including $587.2 million in fixed maturities and $88.5 million in limited partnerships. Fixed maturities were 85% of invested assets; 15% of that portfolio was rated non-investment grade. Municipal securities represented 39% of fixed maturities.
Outlook, risks and contingencies
- Management said it expects the Exchange’s pricing actions to result in a net increase in direct written premium in 2016, while noting that coverage reductions or business-mix changes could affect premium levels. Rate changes take time to flow through renewals and earned premiums.
- Management expected 2016 pension-plan costs of $30.0 million before affiliate reimbursements, down from $40.0 million in 2015; Indemnity’s expected share after reimbursements was approximately $12.9 million. A $17.4 million pension contribution was made in January 2016.
- Management stated that operating cash flows should meet normal operating needs and that liquidity was sufficient for 2016, including in continued market volatility. The company cited cash, available credit and investment assets as liquidity sources. Limited partnership investments are less liquid, and $19.1 million of additional partnership commitments remained.
- Indemnity depends on the Exchange for substantially all its revenue. Risks include reduced premiums or a lower management-fee rate, rising commissions and employee costs, agency or competitive pressures, catastrophes, regulatory changes, investment losses, cyber or operational disruption, and concentration of unsecured receivables from the Exchange.
- The Exchange and its property-and-casualty subsidiaries held A.M. Best financial-strength ratings of A+ (“Superior”) with a stable outlook, as reported in the filing.
- A lawsuit by alleged Exchange subscribers claims approximately $308 million in service charges should have gone to the Exchange and seeks an accounting of intercompany transactions. In January 2016, the Pennsylvania Commonwealth Court vacated the Insurance Department’s ruling and directed the matter back to the Court of Common Pleas. Indemnity said it would defend the claims; the filing states legal losses are not expected to be material but notes that some proceedings cannot be reasonably estimated.
- The filing reports a $22.6 million contingent liability relating to pension-plan annuity contracts issued by Erie Family Life Insurance Company. It also reports a $25 million surplus note receivable from that insurer; principal and interest payments require Pennsylvania Insurance Commissioner approval.
Most important facts for investors to verify
- Whether Exchange premium growth and retention continue, and whether pricing actions support profitable growth.
- Whether commission, personnel and benefit-cost increases continue to outpace revenue growth and pressure margins.
- The quality and liquidity of investments, including non-investment-grade fixed maturities, limited partnerships, and partnership valuations reported with a lag.
- The status and potential financial consequences of the subscriber lawsuits, including any further appeal or return to state court.
- Whether the 25% management-fee rate and Indemnity’s significant receivables from its sole customer remain sustainable.
- The effects of the retrospective consolidation change when comparing 2015 results with previously published financial statements.