ERIE INDEMNITY COMPANY The following discussion of financial condition and results of operations highlights significant factors influencingErie Indemnity Company ("Indemnity", "we", "us", "our"). This discussion should be read in conjunction with the historical financial statements and the related notes thereto included in Part I, Item 1. "Financial Statements" of this Quarterly Report on Form 10-Q, and with Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations" for the year endedDecember 31, 2019 , as contained in our Annual Report on Form 10-K filed with theSecurities and Exchange Commission onFebruary 27, 2020 . INDEX Page Number
Cautionary Statement Regarding Forward-Looking Information 25 Recent Accounting Standards 26 Operating Overview 26 Results of Operations 29 Financial Condition 35 Liquidity and Capital Resources 37 Critical Accounting Estimates 39
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION
"Safe Harbor" Statement under the Private Securities Litigation Reform Act of 1995: Statements contained herein that are not historical fact are forward-looking statements and, as such, are subject to risks and uncertainties that could cause actual events and results to differ, perhaps materially, from those discussed herein. Forward-looking statements relate to future trends, events or results and include, without limitation, statements and assumptions on which such statements are based that are related to our plans, strategies, objectives, expectations, intentions, and adequacy of resources. Examples of forward-looking statements are discussions relating to premium and investment income, expenses, operating results, and compliance with contractual and regulatory requirements. Forward-looking statements are not guarantees of future performance and involve risks and uncertainties that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in such forward-looking statements. Among the risks and uncertainties, in addition to those set forth in our filings with theSecurities and Exchange Commission , that could cause actual results and future events to differ from those set forth or contemplated in the forward-looking statements include the following: •potential impacts of the COVID-19 pandemic on the growth and financial condition of theErie Insurance Exchange ("Exchange"); •potential impacts of the COVID-19 pandemic on our operations, the business operations of our customers and/or independent agents, or our third-party vendor operations; •dependence upon our relationship with the Exchange and the management fee under the agreement with the subscribers at the Exchange; •dependence upon our relationship with the Exchange and the growth of the Exchange, including: •general business and economic conditions; •factors affecting insurance industry competition; •dependence upon the independent agency system; and •ability to maintain our reputation for customer service; •dependence upon our relationship with the Exchange and the financial condition of the Exchange, including: •the Exchange's ability to maintain acceptable financial strength ratings; •factors affecting the quality and liquidity of the Exchange's investment portfolio; •changes in government regulation of the insurance industry; •emerging claims and coverage issues in the industry; and •severe weather conditions or other catastrophic losses, including terrorism; •costs of providing policy issuance and renewal services to the Exchange under the subscriber's agreement; •ability to attract and retain talented management and employees; •ability to ensure system availability and effectively manage technology initiatives; •difficulties with technology or data security breaches, including cyber attacks; •ability to maintain uninterrupted business operations; 25
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Table of Contents •factors affecting the quality and liquidity of our investment portfolio; •our ability to meet liquidity needs and access capital; and •outcome of pending and potential litigation.
A forward-looking statement speaks only as of the date on which it is made and reflects our analysis only as of that date. We undertake no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events, changes in assumptions, or otherwise.
RECENT ACCOUNTING STANDARDS
See Part I, Item 1. "Financial Statements - Note 2, Significant Accounting Policies, of Notes to Financial Statements" contained within this report for a discussion of recently adopted as well as other recently issued accounting standards and the impact on our financial statements if known.
OPERATING OVERVIEW
Overview
We serve as the attorney-in-fact for the subscribers (policyholders) at the
Exchange, a reciprocal insurer that writes property and casualty insurance. Our
primary function as attorney-in-fact is to perform policy issuance and renewal
services on behalf of the subscribers at the Exchange. We also act as
attorney-in-fact on behalf of the Exchange, as well as the service provider for
its insurance subsidiaries, with respect to all administrative services.
The Exchange is a reciprocal insurance exchange, which is an unincorporated
association of individuals, partnerships and corporations that agree to insure
one another. Each applicant for insurance to the Exchange signs a subscriber's
agreement, which contains an appointment of Indemnity as their attorney-in-fact
to transact the business of the Exchange on their behalf. Pursuant to the
subscriber's agreement for acting as attorney-in-fact in these two
capacities, we earn a management fee calculated as a percentage of the direct
and affiliated assumed premiums written by the Exchange.
Our earnings are primarily driven by the management fee revenue generated for
the services we provide to the Exchange. The policy issuance and renewal
services we provide to the Exchange are related to the sales, underwriting and
issuance of policies. The sales related services we provide include agent
compensation and certain sales and advertising support services. Agent
compensation includes scheduled commissions to agents based upon premiums
written as well as additional commissions and bonuses to agents, which are
earned by achieving targeted measures. Agent compensation generally comprises
approximately two-thirds of our policy issuance and renewal expenses. The
underwriting services we provide include underwriting and policy processing. The
remaining services we provide include customer service and administrative
support. We also provide information technology services that support all the
functions listed above. Included in these expenses are allocations of costs for
departments that support these policy issuance and renewal functions.
By virtue of its legal structure as a reciprocal insurer, the Exchange does not
have any employees or officers. Therefore, it enters into contractual
relationships by and through an attorney-in-fact. Indemnity serves as the
attorney-in-fact on behalf of the Exchange with respect to its administrative
services. The Exchange's insurance subsidiaries also utilize Indemnity for these
services in accordance with the service agreements between each of the
subsidiaries and Indemnity. Claims handling services include costs incurred in
the claims process, including the adjustment, investigation, defense, recording
and payment functions. Life insurance management services include costs incurred
in the management and processing of life insurance business. Investment
management services are related to investment trading activity, accounting and
all other functions attributable to the investment of funds. Included in these
expenses are allocations of costs for departments that support these
administrative functions. The amounts incurred for these services are reimbursed
to Indemnity at cost in accordance with the subscriber's agreement and the
service agreements. State insurance regulations require that intercompany
service agreements and any material amendments be approved in advance by the
state insurance department.
Our results of operations are tied to the growth and financial condition of the
Exchange as the Exchange is our sole customer, and our earnings are largely
generated from management fees based on the direct and affiliated assumed
premiums written by the Exchange. The Exchange generates revenue by insuring
preferred and standard risks, with personal lines comprising 71% of the 2019
direct and affiliated assumed written premiums and commercial lines comprising
the remaining 29%. The principal personal lines products are private passenger
automobile and homeowners. The principal commercial lines products are
commercial multi-peril, commercial automobile and workers compensation.
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Coronavirus ("COVID-19") pandemic
On March 11, 2020 , the outbreak of the coronavirus ("COVID-19") was declared a
global pandemic. The significant volatility in the financial markets, economic
disruption and uncertainty resulting from the COVID-19 pandemic that began in
the first quarter of 2020 continues to evolve and the pandemic's ultimate impact
and duration remain highly uncertain at this time.
The uncertainty of the COVID-19 pandemic has caused our sole customer, the
Exchange, to experience growth constraints, which impacts our management fee
revenue. The Exchange experienced declines in new business in the second quarter
of 2020 due to business disruptions and recessionary conditions. Continued
impacts of the COVID-19 pandemic will likely be incurred in the second half of
2020 and may continue until such time as the spread of the virus is contained.
The Exchange previously announced rate reductions that will reduce its premiums
and our management fee revenue beginning in the second half of 2020. Also, there
may be other market and/or regulatory pressures that could impact the Exchange's
operations. In the first half of 2020, within our cost of operations, we
incurred increased agent incentive costs as lower claim frequency resulted in
improved agent profitability. We have incurred additional technology costs in
support of remote working conditions for our employees. These expenses, among
others, could continue to increase as the full extent and duration of the
pandemic's impacts remain uncertain. While the financial market volatility had a
negative impact on our investment portfolio in the first quarter of 2020,
markets did experience a partial recovery in the second quarter of 2020,
contributing to realized and unrealized gains during this period. We could
experience future losses and/or impairments to the portfolio given the
pandemic's impacts on market conditions. We have provided additional disclosure
of these impacted areas throughout our Management's Discussion and Analysis that
follows. A broader discussion of the potential future impacts has also been
disclosed in the Financial Condition, Liquidity and Capital Resources, and Part
II. Item 1A. "Risk Factors" related to COVID-19 contained within this report.
We have a dedicated internal committee comprised of management from various
finance disciplines reviewing our risk positions on an ongoing basis as
circumstances are evolving. The committee is reviewing risk scenarios and
performing stress tests, including the review of cash flow trends, liquidity
requirements and other forms of risk quantification. This provides tools for
management, as well as our Risk Committee of the Board of Directors, to assess
risks and prioritize key issues.
While we were not required to close our physical locations under the state
mandated closure of nonessential services, out of concern for the health and
safety of our employees, over 90% of our workforce has been working remote since
about March 12, 2020 . We have had no significant interruption to our core
business processes or systems to date. We have had no significant changes to our
financial close or reporting processes or related internal controls, nor do we
anticipate any significant future challenges at this time. We have a separate
dedicated committee developing a return to the office plan that will be
implemented when it becomes feasible and safe.
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Financial Overview
Three months ended June 30, Six months ended June 30,
(dollars in thousands, except
per share data) 2020 2019 % Change 2020 2019 % Change
(Unaudited) (Unaudited)
Operating income $ 91,189 $ 96,610 (5.6) % $ 176,880 $ 182,732 (3.2) %
Total investment income 11,553 9,652 19.7 2,358 19,447 (87.9)
Interest expense, net 2 272 NM 5 721 NM
Other (expense) income (258) 48 NM (624) 95 NM
Income before income taxes 102,482 106,038 (3.4) 178,609 201,553 (11.4)
Income tax expense 20,505 18,284 12.1 37,306 38,488 (3.1)
Net income $ 81,977 $ 87,754 (6.6) % $ 141,303 $ 163,065 (13.3) %
Net income per share - diluted $ 1.57 $ 1.68 (6.6) % $ 2.70 $ 3.12 (13.3) %
NM = not meaningful
Operating income decreased in both the second quarter and six months ended
June 30, 2020 , compared to the same periods in 2019, as growth in operating
expenses outpaced the growth in operating revenues. Management fee revenue for
policy issuance and renewal services increased 0.7% to $483.8 million in the
second quarter and 1.8% to $927.5 million for the six months ended June 30,
2020 , respectively. Management fee revenue is based upon the management fee rate
we charge, and the direct and affiliated assumed premiums written by the
Exchange. The management fee rate was 25% for both 2020 and 2019. The direct and
affiliated assumed premiums written by the Exchange increased 0.5% to $2.0
billion in the second quarter of 2020 and increased 1.9% to $3.9 billion for the
six months ended June 30, 2020 , compared to the same periods in 2019.
Cost of operations for policy issuance and renewal services increased 2.2% to
$413.9 million and 3.0% to $793.4 million in the second quarter and six months
ended June 30, 2020 , compared to the same periods in 2019, primarily due to
higher agent incentives driven by lower claims frequency.
Management fee revenue for administrative services increased 4.4% to $14.8
million in the second quarter of 2020 and increased 5.1% to $29.6 million for
the six months ended June 30, 2020 , compared to the same periods in 2019. The
administrative services reimbursement revenue and corresponding cost of
operations increased both total operating revenue and total operating expenses
by $152.0 million in the second quarter of 2020 and $303.5 million for the six
months ended June 30, 2020 , but had no net impact on operating income.
While our investment portfolio was negatively impacted by the significant
disruption to financial markets in the first quarter of 2020, market conditions
partially recovered in the second quarter of 2020. Total investment income
increased $1.9 million in the second quarter of 2020 compared to the second
quarter of 2019 primarily driven by an increase in net realized gains of $5.2
million partially offset by an increase in losses of limited partnerships of
$2.7 million . Investment income decreased $17.1 million during the six months
ended June 30, 2020 compared to the six months ended June 30, 2019 primarily
driven by net realized losses of $4.3 million , impairment losses of $3.1 million
and limited partnership losses of $6.0 million .
General Conditions and Trends Affecting Our Business
Economic conditions
Unfavorable changes in economic conditions, including declining consumer
confidence, inflation, high unemployment, and the threat of recession, among
others, may lead the Exchange's customers to modify coverage, not renew
policies, or even cancel policies, which could adversely affect the premium
revenue of the Exchange, and consequently our management fee. The extent to
which economic conditions could impact the Exchange's operations and our
management fee was exacerbated with the COVID-19 pandemic. The extent and
duration of the impacts to economic conditions remain uncertain as the pandemic
continues to evolve. See Financial Condition, Liquidity and Capital Resources,
and Part II, Item 1A. "Risk Factors" contained within this report for a
discussion of the potential impacts of the COVID-19 pandemic on our operations.
Financial market volatility
Our portfolio of fixed maturity, equity security, and limited partnership
investments is subject to market volatility, especially in periods of
instability in the worldwide financial markets. Over time, net investment
income could also be impacted by volatility and by the general level of interest
rates, which impact reinvested cash flow from the portfolio and business
operations. Depending upon market conditions, which are unpredictable and remain
uncertain, considerable fluctuation could exist in the fair value of our
investment portfolio and reported total investment income, which could have an
adverse impact on our financial condition, results of operations, and cash
flows. Significant volatility has been seen in the global financial markets
since the outbreak of the COVID-19 pandemic. The extent of the impact on our
invested assets cannot be estimated with a high
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degree of certainty at this time given the ongoing developments of this pandemic
and the related impacts on the financial markets.
RESULTS OF OPERATIONS
Management fee revenue We have two performance obligations in the subscriber's agreement, providing policy issuance and renewal services and acting as attorney-in-fact for the Exchange, as well as the service provider for its insurance subsidiaries, with respect to all administrative services. We earn management fees for acting as the attorney-in-fact for the subscribers at the Exchange in these two capacities, and allocate our revenues between our performance obligations. The management fee is calculated by multiplying all direct and affiliated assumed premiums written by the Exchange by the management fee rate, which is determined by our Board of Directors at least annually. The management fee rate was set at 25%, the maximum rate, for both 2020 and 2019. Changes in the management fee rate can affect our revenue and net income significantly. The transaction price, including management fee revenue and administrative service reimbursement revenue, is allocated based on the estimated standalone selling prices developed using industry information and other available information for similar services. We update the transaction price allocation annually based upon the most recent information available or more frequently if there have been significant changes in any components considered in the transaction price. In 2020, we are reviewing our transaction price allocation quarterly to consider the most current economic conditions related to the COVID-19 pandemic. These reviews have resulted in no material change to the allocation.
The following table presents the allocation and disaggregation of revenue for our two performance obligations:
Three months ended June 30, Six months ended June 30,
(dollars in thousands) 2020 2019 % Change 2020 2019 % Change
(Unaudited) (Unaudited)
Policy issuance and renewal services
Direct and affiliated assumed premiums written by
the Exchange $ 2,002,753 $ 1,993,593 0.5 % $ 3,850,431 $ 3,778,113 1.9 %
Management fee rate 24.2 % 24.2 % 24.2 % 24.2 %
Management fee revenue 484,666 482,449 0.5 931,804 914,303 1.9Change in allowance for management fee returned on cancelled policies (1)
(871) (1,936) 55.0 (4,259) (2,807) (51.7)
Management fee revenue - policy issuance and renewal services, net$ 483,795 $ 480,513 0.7 %$ 927,545 $ 911,496 1.8 % Administrative services Direct and affiliated assumed premiums written by the Exchange$ 2,002,753 $ 1,993,593 0.5 %$ 3,850,431 $ 3,778,113 1.9 % Management fee rate 0.8 % 0.8 % 0.8 % 0.8 % Management fee revenue 16,022 15,949 0.5 30,803 30,225 1.9 Change in contract liability (2) (1,184) (1,742) 32.0 (1,183) (2,052) 42.3
Change in allowance for management fee returned on cancelled policies (1)
(25) (12) NM (36) (27) (32.1)
Management fee revenue - administrative services,
net 14,813 14,195 4.4 29,584 28,146 5.1
Administrative services reimbursement revenue 151,965 146,095 4.0 303,519 288,575 5.2
Total revenue from administrative services$ 166,778 $ 160,290 4.0 %$ 333,103 $ 316,721 5.2 % NM = not meaningful (1)Management fees are returned to the Exchange when policies are cancelled mid-term and unearned premiums are refunded. We record an estimated allowance for management fees returned on mid-term policy cancellations. This estimated allowance has been allocated between the two performance obligations consistent with the revenue allocation proportion. In the three and six months endedJune 30, 2020 the increase in the allowance for management fee returned on cancelled policies was driven by the potential for a greater number of mid-term cancellations as a result of the COVID-19 pandemic. (2)Management fee revenue - administrative services is recognized over time as the services are performed. See Part I, Item 1. "Financial Statements - Note 3, Revenue, of Notes to Financial Statements" contained within this report. 29 -------------------------------------------------------------------------------- Table of Contents Direct and affiliated assumed premiums written by the Exchange Direct and affiliated assumed premiums include premiums written directly by the Exchange and premiums assumed from its wholly owned property and casualty subsidiaries. Direct and affiliated assumed premiums written by the Exchange increased 0.5% to$2.0 billion in the second quarter of 2020 compared to the second quarter of 2019, driven by increases in both policies in force and average premium per policy. Year-over-year policies in force for all lines of business increased 1.1% in the second quarter of 2020 driven by continuing strong policyholder retention, compared to 2.7% in the second quarter of 2019. The year-over-year average premium per policy for all lines of business increased 2.2% atJune 30, 2020 , compared to 3.4% atJune 30, 2019 . Premiums generated from new business decreased 18.6% to$190 million in the second quarter of 2020 driven by shelter-at-home orders, changes in consumer behavior and driving patterns and mandatory business closures resulting from the COVID-19 pandemic. Year-over-year average premium per policy on new business decreased 0.4% atJune 30, 2020 and new business polices written decreased 12.7% in the second quarter of 2020. In the second quarter of 2019, premiums generated from new business decreased 1.1% to$233 million . While year-over-year average premium per policy on new business increased 6.4% atJune 30, 2019 , new business polices written decreased 7.4% in the second quarter of 2019. Premiums generated from renewal business increased 3.0% to$1.8 billion in the second quarter of 2020, compared to an increase of 6.6% in the second quarter of 2019. Underlying the trend in renewal business premiums was an increase in year-over-year average premium per policy of 2.5% atJune 30, 2020 compared to 2.9% atJune 30, 2019 , respectively. Personal lines - Total personal lines premiums written increased 0.7% to$1.4 billion in the second quarter of 2020 compared to the second quarter of 2019, driven by an increase of 1.1% in total personal lines policies in force and an increase of 1.7% in the total personal lines year-over-year average premium per policy. The impacts of the COVID-19 pandemic, including changes in consumer behavior and driving patterns, among others, impacted new personal policies written, which decreased 10.5% in the second quarter of 2020. These impacts were experienced primarily in April and May of 2020, with declines of 23.9% and 13.4%, respectively, while inJune 2020 new personal policies written increased 7.0%. In the second quarter of 2019, new personal policies written decreased by 8.9%. Commercial lines - Total commercial lines premiums written decreased 0.1% to$579 million in the second quarter of 2020 compared to the second quarter of 2019, driven by a 1.2% increase in total commercial lines policies in force and a 3.3% increase in total commercial lines year-over-year average premium per policy. New commercial business polices written decreased 24.1% in the second quarter of 2020. The significant decrease in 2020 was the result of the disruptions to businesses, including mandatory business closures, and economic conditions resulting from the COVID-19 pandemic. April and May of 2020 experienced larger declines, with new commercial business policies written decreasing 36.1% and 24.2%, respectively, while June of 2020 decreased 2.7%. In the second quarter of 2019, new commercial policies written increased 1.4%. Future trends-premium revenue - Changes in premium levels attributable to the growth in policies in force and rate changes directly affect the profitability of the Exchange and have a direct bearing on our management fee. The COVID-19 pandemic may have a negative impact on the Exchange's premiums, and therefore our management fees, given recessionary economic conditions and related declines in consumer activity and demand for certain services, as well as the potential for sustained changes in driving patterns. In response to reduced exposure given lower driving activity, and to provide financial relief to policyholders as a result of the COVID-19 pandemic, the Exchange previously announced$200 million in personal and commercial auto rate reductions that will take effect at the time of policy initiations or renewal, beginningJuly 1, 2020 . These rate reductions will reduce the Exchange's 2020 premiums written by approximately$90 million , which will result in an estimated$23 million reduction in our 2020 management fee revenue. The remaining portion of these rate reductions will impact both the Exchange's premium written and our management fee revenue in 2021. Future premiums could also be impacted by potential regulatory changes resulting from the COVID-19 pandemic. Through a careful agency selection process, the Exchange plans to continue its effort to expand the size of its agency force to increase market penetration in existing operating territories to contribute to future growth. While our agents initially experienced business declines resulting from disruptions created by the COVID-19 pandemic, there have been no significant disruptions in their operations. The continued impacts of the COVID-19 pandemic could make it difficult for our independent agents to write new business and retain existing business and/or constrain our ability to recruit new agents.
The extent of the impact to the Exchange's premiums and our management fee cannot be estimated with a high degree of certainty at this time given the ongoing developments related to this pandemic. See also Part II. Item 1A. "Risk Factors" contained within this report.
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Policy issuance and renewal services
Three months ended June 30, Six months ended June 30,
(dollars in thousands) 2020 2019 % Change 2020 2019 % Change
(Unaudited) (Unaudited)
Management fee revenue - policy issuance and
renewal services, net $ 483,795 $ 480,513 0.7 % $ 927,545 $ 911,496 1.8 %
Service agreement revenue 6,446 6,907 (6.7) 13,108 13,599 (3.6)
490,241 487,420 0.6 940,653 925,095 1.7Cost of policy issuance and renewal services 413,865 405,005
2.2 793,357 770,509 3.0
Operating income - policy issuance and renewal
services $ 76,376 $ 82,415 (7.3) % $ 147,296 $ 154,586 (4.7) %
Policy issuance and renewal services
We allocate a portion of the management fee, which currently equates to 24.2% of
the direct and affiliated assumed premiums written by the Exchange, for
providing policy issuance and renewal services. This portion of the management
fee is recognized as revenue when the policy is issued or renewed because it is
at that time that the services we provide are substantially complete and the
executed insurance policy is transferred to the customer. The increase in
management fee revenue for policy issuance and renewal services was driven by
the increase in the direct and affiliated assumed premiums written by the
Exchange discussed previously.
Service agreement revenue
Service agreement revenue includes service charges we collect from
subscribers/policyholders for providing extended payment terms on policies
written and assumed by the Exchange, and late payment and policy reinstatement
fees. The service charges are fixed dollar amounts per billed installment. The
decrease in service agreement revenue for the three and six months ended 2020 reflects the continued shift to payment plans that do not incur service charges or offer a premium discount for certain payment methods.
Cost of policy issuance and renewal services
Three months ended June 30, Six months ended June 30,
(dollars in thousands) 2020 2019 (1) % Change 2020 2019 % Change
(Unaudited) (Unaudited)
Commissions:
Total commissions $ 278,478 $ 273,256 1.9 % $ 530,474 $ 516,238 2.8 %
Non-commission expense:
Underwriting and policy processing $ 39,891 $ 40,220 (0.8) % $ 81,243 $ 78,445 3.6 %
Information technology 43,155 40,847 5.7 85,313 79,994 6.7
Sales and advertising 15,770 14,193 11.1 27,245 25,202 8.1
Customer service 8,631 8,319 3.8 17,210 16,336 5.4
Administrative and other 27,940 28,170 (0.8) 51,872 54,294 (4.5)
Total non-commission expense 135,387 131,749 2.8 262,883 254,271 3.4
Total cost of policy issuance and renewal
services $ 413,865 $ 405,005 2.2 % $ 793,357 $ 770,509 3.0 %
(1)Three months ended
Commissions - Commissions increased$5.2 million in the second quarter of 2020 and$14.2 million for the six months endedJune 30, 2020 compared to the same periods in 2019, primarily driven by increases in agent incentive compensation. The estimated agent incentive payouts atJune 30, 2020 are based on actual underwriting results for the two prior years and current year-to-date actual results and forecasted results for the remainder of 2020. Therefore, fluctuations in the current quarter underwriting results can impact the estimated incentive payout on a quarter-to-quarter basis. The Exchange experienced a significant decrease in automobile claims frequency and related loss expense beginning inMarch 2020 that continued through the second quarter of 2020 driven by the impacts of the COVID-19 pandemic. If a sustained period of lower claims frequency and loss expenses occurs, our agent compensation could increase related to the profitability component of the agent incentive bonuses. While lower than historical comparative periods, the Exchange's claims frequency began to trend upward in June 31 -------------------------------------------------------------------------------- Table of Contents 2020. Growth in direct and affiliated assumed premiums written by the Exchange of 0.5% in the second quarter of 2020 and 1.9% for the six months endedJune 30, 2020 also contributed to the increase in commission expenses compared to the same periods in 2019. Non-commission expense - Non-commission expense increased$3.6 million in the second quarter of 2020 compared to the second quarter of 2019. Information technology costs increased$2.3 million driven by increases in hardware and software costs primarily to support remote work capabilities for our employees and professional fees. Sales and advertising costs increased$1.6 million primarily driven by a new program to support agent charitable giving in response to the COVID-19 pandemic. Personnel costs in all categories increased slightly as increases in salaries and wages resulting from higher vacation accruals were partially offset by lower medical expenses due to the COVID-19 pandemic. Non-commission expense increased$8.6 million in the six months endedJune 30, 2020 compared to the same period in 2019. Information technology costs increased$5.3 million primarily due to increases in hardware and software costs, professional fees, and personnel costs. Underwriting and policy processing expense increased$2.8 million primarily due to increases in personnel costs. Sales and advertising costs increased$2.0 million primarily driven by personnel costs and a new program to support agent charitable giving in response to the COVID-19 pandemic. Administrative and other costs decreased$2.4 million primarily driven by the change in the company stock price, which experienced a lower increase during the six months endedJune 30, 2020 compared to the same period in 2019. Increased personnel costs in all categories included higher vacation accruals as employees took less vacation in the first six months as a result of the COVID-19 pandemic. Administrative services Three months ended June 30, Six months ended June 30, (dollars in thousands) 2020 2019 % Change 2020 2019 % Change (Unaudited) (Unaudited) Management fee revenue - administrative services, net$ 14,813 $ 14,195 4.4 %$ 29,584 $ 28,146 5.1 % Administrative services reimbursement revenue 151,965 146,095 4.0 303,519 288,575 5.2 Total revenue allocated to administrative services 166,778 160,290 4.0 333,103 316,721 5.2 Administrative services expenses Claims handling services 131,474 127,296 3.3 263,777 251,495 4.9 Investment management services 8,353 8,402 (0.6) 17,410 17,185 1.3 Life management services 12,138 10,397 16.7 22,332 19,895 12.2
Operating income - administrative services
4.4 %$ 29,584 $ 28,146 5.1 % Administrative services We allocate a portion of the management fee, which currently equates to 0.8% of the direct and affiliated assumed premiums written by the Exchange, to the administrative services. This portion of the management fee is recognized as revenue over a four-year period representing the time over which the services are provided. We also report reimbursed costs as revenues, which are recognized monthly as services are provided. The administrative services expenses we incur and the related reimbursements we receive are recorded gross in the Statements of Operations. Cost of administrative services By virtue of its legal structure as a reciprocal insurer, the Exchange does not have any employees or officers. Therefore, it enters into contractual relationships by and through an attorney-in-fact. Indemnity serves as the attorney-in-fact on behalf of the Exchange with respect to its administrative services in accordance with the subscriber's agreement. The Exchange's insurance subsidiaries also utilize Indemnity for these services in accordance with the service agreements between each of the subsidiaries and Indemnity. The amounts incurred for these services are reimbursed to Indemnity at cost in accordance with the subscriber's agreement and the service agreements. We record these reimbursements due from the Exchange and its insurance subsidiaries as a receivable. 32 -------------------------------------------------------------------------------- Table of Contents Total investment income A summary of the results of our investment operations is as follows: Three months ended June 30, Six months ended June 30, (dollars in thousands) 2020 2019 % Change 2020 2019 % Change (Unaudited) (Unaudited) Net investment income$ 7,373 $ 8,030 (8.2) %$ 15,742 $ 16,547 (4.9) % Net realized investment gains (losses) 6,526 1,302 NM (4,280) 3,805 NM Net impairment losses recognized in earnings (17) (84) (79.1) (3,070) (162) NM Equity in (losses) earnings of limited partnerships (2,329) 404 NM (6,034) (743) NM Total investment income$ 11,553 $ 9,652 19.7 %$ 2,358 $ 19,447 (87.9) % NM = not meaningful Net investment income Net investment income primarily includes interest and dividends on our fixed maturity and equity security portfolios, net of investment expenses. Net investment income decreased by$0.7 million in the second quarter of 2020 and$0.8 million for the six months endedJune 30, 2020 , compared to the same periods in 2019. The results from both periods were primarily due to decreased income generated from cash and cash equivalents driven by lower rates and invested balances, somewhat offset by increased preferred stock dividends resulting from higher invested balances. Net realized investment gains (losses) A breakdown of our net realized investment gains (losses) is as follows: Three months ended June 30, Six months ended June 30, (in thousands) 2020 2019 2020 2019 Securities sold: (Unaudited) (Unaudited) Available-for-sale securities $ 355$ 1,239 $ 970 $ 3,157 Equity securities (1,840) 0 (2,528) 0 Equity securities change in fair value 8,010 63 (2,724) 648 Miscellaneous 1 0 2 0 Net realized investment gains (losses)$ 6,526 $ 1,302 $ (4,280) $ 3,805 Market value adjustments of equity securities are recognized in net realized investment gains (losses) in the Statements of Operations. While net realized gains of$6.5 million in the second quarter of 2020 reflected a partial financial market recovery, net realized losses of$4.3 million for the six months endedJune 30, 2020 reflect an overall decrease as a result of the COVID-19 pandemic driven by the significant volatility in the first quarter of 2020. Net realized gains during the second quarter and six months endedJune 30, 2019 were primarily driven by gains from sales of available-for-sale securities. Net impairment losses recognized in earnings Improvements in market conditions during the second quarter of 2020 resulted in lower impairment losses. Net impairment losses recognized on available-for-sale securities during the six months endedJune 30, 2020 include$2.2 million of securities in an unrealized loss position where we had intent to sell prior to recovery of our amortized cost basis and$0.7 million of credit impairment losses. The remaining impairments include the change in the current expected credit loss allowance related to our agent loans. The COVID-19 pandemic's impact on financial markets contributed to higher impairment losses on our available-for-sale securities during the first six months of 2020 compared to the same period in 2019. Equity in (losses) earnings of limited partnerships Limited partnership results for both the second quarter and six months endedJune 30, 2020 compared to the second quarter and six months endedJune 30, 2019 were due primarily to increased losses in the private equity sector. Financial condition ofErie Insurance Exchange Serving in the capacity of attorney-in-fact for the Exchange, we are dependent on the growth and financial condition of the Exchange, who is our sole customer. The strength of the Exchange and its wholly owned subsidiaries is rated annually byA.M. Best Company through assessing its financial stability and ability to pay claims. The ratings are generally based upon factors relevant to policyholders and are not directed toward return to investors. The Exchange and each of its property and casualty subsidiaries are rated A+ "Superior", the second highest financial strength rating, which is assigned to companies that have achieved superior overall performance when compared to the standards established byA.M. Best and have a superior ability to 33
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meet obligations to policyholders over the long term. On
The financial statements of the Exchange are prepared in accordance with statutory accounting principles prescribed by theCommonwealth of Pennsylvania . Financial statements prepared under statutory accounting principles focus on the solvency of the insurer and generally provide a more conservative approach than underU.S. generally accepted accounting principles. Statutory direct written premiums of the Exchange and its wholly owned property and casualty subsidiaries grew 1.9% to$3.9 billion for the six months endedJune 30, 2020 compared to the six months endedJune 30, 2019 . These premiums, along with investment income, are the major sources of cash that support the operations of the Exchange. Policyholders' surplus determined under statutory accounting principles was$9.4 billion atJune 30, 2020 ,$9.5 billion atDecember 31, 2019 , and$9.0 billion atJune 30, 2019 . The Exchange and its wholly owned property and casualty subsidiaries' year-over-year policy retention ratio continues to be high at 89.9% atJune 30, 2020 , 90.0% atDecember 31, 2019 , and 90.2% atJune 30, 2019 . We have prepared our financial statements considering the financial strength of the Exchange based on its AM Best rating and strong level of surplus. We are monitoring risks related to the COVID-19 pandemic on an ongoing basis and believe that the Exchange falls within defined risk tolerances. However, see Part II. Item 1A. "Risk Factors" for possible outcomes that could impact that determination. 34 -------------------------------------------------------------------------------- Table of Contents FINANCIAL CONDITION The financial market conditions resulting from the COVID-19 pandemic partially recovered in the second quarter of 2020 which resulted in a favorable impact on our investment portfolio; however, we could experience further reductions in the market value of our investment portfolio as long as market conditions remain volatile in response to the developments of this pandemic and the related economic impacts.
Investments
Our investment portfolio is managed with the objective of maximizing after-tax returns on a risk-adjusted basis. The following table presents the carrying value of our investments as of:
(dollars in thousands) June 30, 2020 % to total December 31, 2019 % to total
(Unaudited)
Fixed maturities $ 804,825 83 % $ 730,701 82 %
Equity securities:
Preferred stock 73,973 8 64,752 7
Common stock 1,416 0 2,381 0
Limited partnerships 15,463 2 26,775 3
Agent loans (1) 65,450 7 67,696 8
Other investments 2,046 0 1,430 0
Total investments $ 963,173 100 % $ 893,735 100 %
(1)The current portion of agent loans is included with prepaid expenses and other current assets in the Statements of Financial Position.
Fixed maturities Under our investment strategy, we maintain a fixed maturity portfolio that is of high quality and well diversified within each market sector. This investment strategy also achieves a balanced maturity schedule. Our fixed maturity portfolio is managed with the goal of achieving reasonable returns while limiting exposure to risk. Fixed maturities are carried at fair value with unrealized gains and losses, net of deferred taxes, included in shareholders' equity. Net unrealized gains on fixed maturities, net of deferred taxes, totaled$9.8 million atJune 30, 2020 , compared to net unrealized gains of$4.5 million atDecember 31, 2019 . The following table presents a breakdown of the fair value of our fixed maturity portfolio by industry sector and rating as of: (in thousands) June 30, 2020 (1) Non- investment Fair AAA AA A BBB grade value (Unaudited) Basic materials$ 0 $ 0 $ 3,300 $ 1,152 $ 6,948 $ 11,400 Communications 0 8,910 8,696 8,305 16,928 42,839 Consumer 0 3,256 19,773 56,455 32,864 112,348 Diversified 0 0 0 1,057 497 1,554 Energy 0 4,207 4,707 14,016 11,848 34,778 Financial 0 1,021 59,803 100,623 10,389 171,836 Industrial 0 0 10,182 10,271 12,490 32,943 Structured securities (2) 126,862 174,840 24,716 8,752 0 335,170 Technology 0 3,140 10,197 14,073 7,976 35,386 Utilities 0 0 3,923 16,815 5,833 26,571 Total$ 126,862 $ 195,374 $ 145,297 $ 231,519 $ 105,773 $ 804,825 (1)Ratings are supplied by S&P, Moody's, and Fitch. The table is based upon the lowest rating for each security. (2)Structured securities include residential and commercial mortgage-backed securities, collateralized debt obligations, and asset-backed securities. 35
-------------------------------------------------------------------------------- Table of Contents Equity securities Equity securities consist of nonredeemable preferred and common stock and are carried at fair value in the Statements of Financial Position with all changes in unrealized gains and losses reflected in the Statements of Operations.
The following table presents an analysis of the fair value of our nonredeemable preferred and common stock securities by sector as of:
(in thousands) June 30, 2020 December 31, 2019
Preferred stock Common stock Preferred stock Common stock
(Unaudited)
Communication $ 2,478 $ 1.416 $ 1,052 $ 2,381
Consumer 2,599 0 508 0
Energy 1,035 0 1,881 0
Financial services 60,149 0 53,513 0
Industrial 0 0 980 0
Utilities 7,712 0 6,818 0
Total $ 73,973 $ 1,416 $ 64,752 $ 2,381
36-------------------------------------------------------------------------------- Table of Contents LIQUIDITY AND CAPITAL RESOURCES We continue to monitor the sufficiency of our liquidity and capital resources given the potential impact of the COVID-19 pandemic. We did not see a significant impact on our sources or uses of cash in the first half of 2020. However, we may experience future reductions in our management fee revenue if the Exchange's premium growth is constrained. Also, future disruptions in the markets could occur which may affect our liquidity position. There is potential that the funding requirements for our costs of operations will increase related to agent compensation and technology costs, among others. If our normal operating and investing cash activities were to become insufficient to meet future funding requirements, we believe we have sufficient access to liquidity through our cash position, liquid marketable securities and our$100 million line of credit that does not expire untilOctober 2023 . See broader discussions of potential risks to our operations in the Operating Overview and Part II. Item 1A. "Risk Factors" contained within this report. Sources and Uses of Cash Liquidity is a measure of a company's ability to generate sufficient cash flows to meet the short- and long-term cash requirements of its business operations and growth needs. Our liquidity requirements have been met primarily by funds generated from management fee revenue and income from investments. Cash provided from these sources is used primarily to fund the costs of our management operations including commissions, salaries and wages, pension plans, share repurchases, dividends to shareholders, and the purchase and development of information technology. We expect that our operating cash needs will be met by funds generated from operations. Volatility in the financial markets presents challenges to us as we do occasionally access our investment portfolio as a source of cash. Some of our fixed income investments, despite being publicly traded, may be illiquid. Volatility in these markets could impair our ability to sell certain fixed income securities or cause such securities to sell at deep discounts. We believe we have sufficient liquidity to meet our needs from sources other than the liquidation of securities, even if market volatility persists throughout 2020. Cash flow activities The following table provides condensed cash flow information for the six months endedJune 30 : (in thousands) 2020 2019 (Unaudited) (Unaudited) Net cash provided by operating activities$ 127,282 $ 114,416 Net cash (used in) provided by investing activities (115,423)
42,215
Net cash used in financing activities (90,860)
(84,786)
Net (decrease) increase in cash and cash equivalents
Net cash provided by operating activities was$127.3 million in the first six months of 2020, compared to$114.4 million in the first six months of 2019. Increased cash provided by operating activities in the six months of 2020 was primarily due to an increase of$35.0 million in management fee received driven by growth in direct and affiliated assumed premiums written by the Exchange and a decrease in income taxes paid of$14.2 million driven by lower taxable income compared to the same period in 2019. Offsetting the increase in cash provided by operating activities was a decrease in administrative services reimbursement received of$16.7 million and an increase in cash paid for agent commissions of$14.0 million due to higher scheduled commissions driven by premium growth in the six months of 2020 compared to the same period in 2019. Net cash used in investing activities was$115.4 million in the first six months of 2020, compared to net cash provided by investment activities of$42.2 million in the same period in 2019. In the first six months of 2019, we generated more proceeds from investment sales and maturities/calls, which were somewhat offset by higher purchases of available-for-sale securities due to portfolio rebalancing compared to the same period in 2020. Fixed asset purchases increased$3.2 million over the prior year driven by increases in technology investments, partially offset by decreases in costs related to the home office expansion. We have a commitment for the remaining costs related to the construction of the building that will serve as part of our principal headquarters. Of the total expected cost of$114 million , which was funded primarily by the senior secured draw term loan credit facility,$100.5 million of costs have been paid as ofJune 30, 2020 . Net cash used in financing activities totaled$90.9 million in the first six months of 2020, compared to$84.8 million in the first six months of 2019. The increase in cash used was due to dividends paid to shareholders. Dividends paid to shareholders totaled$89.9 million in the first six months of 2020 and$83.8 million in the first six months of 2019. We increased both our Class A and Class B shareholder regular quarterly dividends by 7.2% for 2020, compared to 2019. There are no regulatory restrictions on the payment of dividends to our shareholders. Future financing activities also include the principal payments 37 -------------------------------------------------------------------------------- Table of Contents due annually over the term of the senior secured draw term loan credit facility, of which$1.0 million will be paid during the remainder of 2020. There were no repurchases of our Class A nonvoting common stock in the first six months of 2020 and 2019 in conjunction with our stock repurchase program. In 2011, our Board of Directors approved a continuation of the current stock repurchase program of$150 million with no time limitation. This repurchase authority includes, and is not in addition to, any unspent amounts remaining under the prior authorization. We had approximately$17.8 million of repurchase authority remaining under this program atJune 30, 2020 , based upon trade date. During the six months endedJune 30, 2020 , we purchased 26,410 shares of our outstanding Class A nonvoting common stock outside of our publicly announced share repurchase program at a total cost of$4.6 million . Of this amount, we purchased 1,787 shares for$0.3 million , or$165.82 per share, for stock-based awards in conjunction with our equity compensation plan. We purchased 3,216 shares for$0.5 million , or$162.53 per share, to fund the rabbi trust for the outside director deferred stock compensation plan. The remaining 21,407 shares were purchased at a total cost of$3.8 million , or$178.34 per share, to fund the rabbi trust for the incentive compensation deferral plan. All shares were delivered as ofJune 30, 2020 . During the six months endedJune 30, 2019 , we purchased 11,964 shares of our outstanding Class A nonvoting common stock outside of our publicly announced share repurchase program at a total cost of$2.0 million . Of this amount, we purchased 3,246 shares for$0.4 million , or$132.35 per share, for stock-based awards in conjunction with our equity compensation plan. We purchased 4,465 shares for$0.9 million , or$190.59 per share, to fund the rabbi trust for the outside director deferred stock compensation plan. The remaining 4,253 shares were purchased at a total cost of$0.7 million , or$175.64 per share, to fund the rabbi trust for the incentive compensation deferral plan. All shares were delivered as ofJune 30, 2019 . Capital Outlook We regularly prepare forecasts evaluating the current and future cash requirements for both normal and extreme risk events, including the current COVID-19 pandemic. Should an extreme risk event result in a cash requirement exceeding normal cash flows, we have the ability to meet our future funding requirements through various alternatives available to us. Outside of our normal operating and investing cash activities, future funding requirements could be met through: 1) cash and cash equivalents, which total approximately$257.7 million atJune 30, 2020 , 2) a$100 million bank revolving line of credit, and 3) liquidation of unpledged assets held in our investment portfolio, including preferred and common stock and investment grade bonds, which totaled approximately$532.3 million atJune 30, 2020 . Volatility in the financial markets could impair our ability to sell certain fixed income securities or cause such securities to sell at deep discounts. Additionally, we have the ability to curtail or modify discretionary cash outlays such as those related to shareholder dividends and share repurchase activities. As ofJune 30, 2020 , we have access to a$100 million bank revolving line of credit with a$25 million letter of credit sublimit that expires onOctober 30, 2023 . As ofJune 30, 2020 , a total of$99.1 million remains available under the facility due to$0.9 million outstanding letters of credit, which reduce the availability for letters of credit to$24.1 million . We had no borrowings outstanding on our line of credit as ofJune 30, 2020 . Investments with a fair value of$124.4 million were pledged as collateral on the line atJune 30, 2020 . The investments pledged as collateral have no trading restrictions and are reported as available-for-sale securities and cash and cash equivalents in the Statements of Financial Position. The banks require compliance with certain covenants, which include leverage ratios and debt restrictions. We were in compliance with our bank covenants atJune 30, 2020 . Off-Balance Sheet Arrangements and Contractual Obligations Off-balance sheet arrangements include those with unconsolidated entities that may have a material current or future effect on our financial condition or results of operations, including material variable interests in unconsolidated entities that conduct certain activities. We have no material off-balance sheet obligations. As ofJune 30, 2020 , there were no material changes to our future contractual obligations as previously reported in our Annual Report on Form 10-K for the year endedDecember 31, 2019 . 38
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Table of Contents CRITICAL ACCOUNTING ESTIMATES We make estimates and assumptions that have a significant effect on the amounts and disclosures reported in the financial statements. The most significant estimates relate to investment valuation and retirement benefit plans for employees. While management believes its estimates are appropriate, the ultimate amounts may differ from estimates provided. Our most critical accounting estimates are described in Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations" for the year endedDecember 31, 2019 of our Annual Report on Form 10-K as filed with theSecurities and Exchange Commission onFebruary 27, 2020 . See Part I, Item 1. "Financial Statements - Note 5, Fair Value, of Notes to Financial Statements" contained within this report for additional information on our valuation of investments.
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