Erie Indemnity Company — FY2010 Form 10-K
Reporting period: Fiscal year ended December 31, 2010. The filing is an annual report, not a standalone fourth-quarter filing; it includes unaudited quarterly results. Unless noted, figures are in U.S. dollars and millions.
Business context and reporting basis
Erie Indemnity manages the Erie Insurance Exchange as its attorney-in-fact and earns a fee based on property-and-casualty premiums. Under accounting guidance adopted retrospectively in 2010, the company consolidates the Exchange, a subscriber-owned reciprocal insurer. Accordingly, consolidated results include policyholder-owned Exchange results as noncontrolling interest; Indemnity shareholders do not own the Exchange’s equity or income.
On December 31, 2010, Indemnity sold its property-and-casualty subsidiaries to the Exchange. Indemnity continues as the management company, while the Exchange now owns all property-and-casualty operations. A separate agreement to sell Indemnity’s 21.6% interest in Erie Family Life (EFL) to the Exchange was expected to close by March 31, 2011.
Financial and operating results
| Metric | FY2010 | FY2009 | Change / context |
|---|---|---|---|
| Total consolidated revenue | $4,890 | $4,255 | Up 14.9% |
| Net income, consolidated | $660 | $446 | Exchange noncontrolling interest accounted for $498 and $338, respectively |
| Net income attributable to Indemnity | $162 | $108 | Up 50%; diluted Class A EPS $2.85 versus $1.89 |
| Operating income attributable to Indemnity (non-GAAP) | $163 | $109 | Excludes realized investment gains/losses, impairments, and related taxes |
| Management fee revenue | $1,009 | $965 | Up 4.6%; 25% fee rate in both years |
| Management operations income before tax | $202 | $187 | Gross margin 19.4%, up from 18.7%; 2010 included a $5 favorable court ruling |
| Property-and-casualty direct written premiums | $4,035 | $3,861 | Up 4.5%; policies in force up 3.3% |
| Property-and-casualty combined ratio | 100.1% | 99.2% | Underwriting loss of $3 versus income of $29; above 100% indicates an underwriting loss |
| Operating cash flow, consolidated | $721 | $889 | Down, primarily reflecting $69 of federal taxes paid versus a $121 tax recovery in 2009 |
Investment performance improved materially: limited-partnership earnings were $128 versus losses of $369 in 2009; recognized investment impairment losses fell to $6 from $126. Net investment income was $433 in both years. Total revenue and consolidated net income also reflect investment results and the Exchange’s policyholder-owned business, not solely Indemnity shareholder operations.
Property-and-casualty losses and loss expenses rose 6.4% to $2,815. Catastrophe losses increased to $288 from $129 and contributed 7.3 points to the loss ratio. Favorable prior-year reserve development was $244, including $188 on direct business; it improved the combined ratio by 4.8 points. The filing reports gross property-and-casualty reserves of $3,584 at year-end, all attributable to the Exchange after the subsidiary sale.
Fourth-quarter 2010 consolidated revenue was $1,401 and net income was $254; net income attributable to Indemnity was $12, or diluted Class A EPS of $0.22. Fourth-quarter 2009 figures were $1,125 revenue, $174 net income, and $24 attributable to Indemnity, or $0.43 diluted EPS.
Financial position, liquidity, and capital
- At December 31, 2010, total assets were $14,344, total liabilities $8,010, and total equity $6,334. Indemnity shareholders’ equity was $912; Exchange noncontrolling interest was $5,422.
- Consolidated cash and cash equivalents were $430, including $310 attributable to Indemnity and $120 to the Exchange. Consolidated investments totaled $11,815.
- Indemnity reported no borrowings under its $100 credit line; the Exchange reported none under its $200 line. Both were in compliance with covenants. The filing does not identify material funded debt outstanding.
- Indemnity’s operating cash flow was $193; its investing activities provided $196, including proceeds associated with the subsidiary sale, and financing activities used $155. Consolidated cash increased $196 during the year.
- Indemnity’s receivables from the Exchange and affiliates were $232, or 17.7% of Indemnity assets, creating a concentration of credit risk. The filing says the Exchange had historically settled amounts owed on time.
- Remaining commitments to limited partnerships totaled $452: $50 for Indemnity and $402 for the Exchange. The Exchange had $3,584 gross property-and-casualty reserves and $1,603 in life policy and deposit contract reserves.
Material changes, outlook, and risks
- Restructuring: The property-and-casualty subsidiary sale generated estimated $285 net after-tax proceeds for Indemnity, with final settlement expected by March 31, 2011. The 2010 subsidiaries contributed $19, or $0.34 per share, to Indemnity net income. The planned EFL sale had estimated gross consideration of about $82 and estimated net after-tax proceeds of $55–$60; a fourth-quarter $18 deferred tax charge was recorded. EFL sale gains or losses were to adjust equity directly because the entities are under common control.
- 2011 outlook: The Board set the management fee rate at its 25% maximum for 2011. Management expected pricing actions to produce a net increase in direct written premium in 2011, while cautioning that economic exposure reductions and changes in business mix could offset growth. The filing provides no quantified earnings guidance.
- Underwriting and catastrophe exposure: Current-year loss ratios excluding catastrophe losses worsened in several lines. Renewed 2011 catastrophe reinsurance provides 90% coverage on losses up to $500 above a $350 retention per occurrence; additional coverage applies above the first treaty’s $850 limit. Terrorism losses are excluded from these treaties, and reinsurance does not remove the insurer’s obligation to policyholders.
- Reserving uncertainty: Reserve estimates depend on claims development, inflation, court outcomes, and long-term medical costs. A 100-basis-point increase in medical-cost inflation would increase combined auto and workers’ compensation massive-injury reserves by $102. Such claims may require payments over 30–40 years.
- Investment and liquidity risk: Equity and limited-partnership valuations are exposed to market movements; partnership results are generally reported on a one-quarter lag and therefore do not reflect fourth-quarter 2010 conditions. Limited partnerships are less liquid, and the group had $452 of unfunded commitments. Management stated it believed liquidity was sufficient for 2011.
- Other risks: Dependence on the Exchange and the management fee, independent-agent distribution, competitive pricing, regulation, technology and cybersecurity, litigation, and reinsurer collectability. AM Best ratings were A+ for the property-and-casualty companies and A for EFL, with stable outlooks. Management said ordinary-course litigation was not expected to be material.
- Capital returns: Indemnity paid $98 in dividends and repurchased $57 of shares under its plan in 2010. Remaining repurchase authority was approximately $146. The filing reports a 7.3% increase in 2011 dividends approved.
- The auditor issued an unqualified opinion on the financial statements and internal controls; management also concluded disclosure controls and internal control over financial reporting were effective.
Most important facts for investors to verify
- How the year-end transfer of property-and-casualty earnings, assets, reserves, and investment results to the Exchange changes Indemnity’s recurring shareholder earnings and cash flows.
- Whether the EFL sale closed on the expected terms and how its final book-value adjustment affected Indemnity equity and future earnings.
- The sustainability of premium growth and management fee income, given the maximum 25% fee rate, competition, economic pressures, and weakening combined ratio.
- The adequacy of reserves and the assumptions behind favorable prior-year development, especially long-tail and massive-injury claims.
- Investment valuation, liquidity, and fourth-quarter lag exposure in limited partnerships, as well as the Exchange’s substantial equity and financial-sector exposures.
- Available liquidity and capital after the transactions, alongside the $452 in limited-partnership funding commitments and the Exchange-related receivable concentration.