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 audited financial statements and related notes and all other items contained within this Annual Report on Form 10-K as these contain important information helpful in evaluating our financial condition and results of operations.
INDEX
Page Number
Cautionary Statement Regarding Forward-Looking Information 20 Recent Accounting Standards 21 Operating Overview 22 Critical Accounting Estimates 25 Results of Operations 29 Financial Condition 36 Investments 36 Shareholders' Equity 37 Home Office Expansion 37 Liquidity and Capital Resources
38
Transactions/Agreements with Related Parties 41
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
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uncertainties, in addition to those set forth in our filings with the Securities
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:
•dependence upon our relationship with the Erie Insurance Exchange ("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;
•litigation and regulatory actions;
•emerging claims and coverage issues in the industry; and
•severe weather conditions or other catastrophic losses, including terrorism;
•potential impacts of the COVID-19 pandemic on the growth and financial
condition of the Exchange;
•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;
•outcome of pending and potential litigation;
•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;
•factors affecting the quality and liquidity of our investment portfolio; and
•our ability to meet liquidity needs and access capital.
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 Item 8. "Financial Statements and Supplementary Data - Note 2, Significant
Accounting Policies, of Notes to Financial Statements" contained within this
report for a discussion of recently adopted accounting standards and the impact
on our financial statements.
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-------------------------------------------------------------------------------- Table of Contents OPERATING OVERVIEW
Overview
We are aPennsylvania business corporation that since 1925 has been the managing 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. Management fee revenue is based upon all direct and affiliated assumed premiums written by the Exchange and the management fee rate, which is not to exceed 25%. Our Board of Directors establishes the management fee rate at least annually, generally in December for the following year. The process of setting the management fee rate includes the evaluation of current year operating results compared to both prior year and industry estimated results for both Indemnity and the Exchange, and consideration of several factors for both entities including: their relative financial strength and capital position; projected revenue, expense and earnings for the subsequent year; future capital needs; as well as competitive position. The management fee rate was set at 25% for 2020, 2019 and 2018. Our Board of Directors set the 2021 management fee rate again at 25%, its maximum level. 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 comprised approximately 66% of our 2020 policy issuance and renewal expenses. The underwriting services we provide include underwriting and policy processing and comprised approximately 10% of our 2020 policy issuance and renewal expenses. The remaining services we provide include customer service and administrative support. We also provide information technology services that support all the functions listed above that comprised approximately 11% of our 2020 policy issuance and renewal expenses. 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 2020 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. We generate investment income from our fixed maturity and equity security portfolios. Our portfolio is managed with the objective of maximizing after-tax returns on a risk-adjusted basis. We actively evaluate the portfolios for securities in an unrealized loss position and record impairment write-downs on investments in instances where we have the intent to sell or it's more likely than not that we would be required to sell the security. Impairments resulting from a credit loss are recognized in earnings with a corresponding allowance on the balance sheet. 22
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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 impact the COVID-19 pandemic has on the premiums written by the Exchange,
our sole customer, affects our management fee revenue. While the Exchange
experienced declines in new business premiums in the first half of 2020 due to
business disruptions and recessionary conditions, new business premiums grew
10.8% in the second half of 2020 compared to the same period in 2019, primarily
driven by growth in the personal auto and homeowners lines of business. The
uncertainty of the ongoing impacts of the COVID-19 pandemic will likely continue
in 2021 and may continue until such time as the spread of the virus is
contained. In response to reduced driving conditions resulting from the COVID-19
pandemic, the Exchange implemented $200 million in personal and commercial auto
rate reductions, which became effective in the third quarter of 2020, resulting
in a decrease of approximately $90 million in the Exchange written premiums and
a corresponding decrease of approximately $22 million in our management fee
revenue in 2020. The remainder of the rate reductions will impact the Exchange's
written premiums and our corresponding management fee revenue in 2021. There may
also be other market and/or regulatory pressures that could impact the
Exchange's operations. In 2020, within our cost of operations, we incurred
increased agent incentive costs as lower claim frequency resulted in improved
agent profitability. We also incurred additional technology costs in support of
remote working conditions for our employees. These expenses, among others, could
continue to persist as the full extent and duration of the pandemic's impacts
remain uncertain. While the financial market volatility created by the COVID-19
pandemic had a negative impact on our investment portfolio in the first quarter
of 2020, markets substantially recovered through the remainder of the year,
resulting in overall realized and unrealized gains in 2020. We could experience
future losses and/or impairments to the portfolio given the pandemic's impact 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 I, 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 and emerging trends 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
March 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 dedicated
team developing a return to the office plan that will be implemented when it
becomes feasible and safe.
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Financial Overview
Years ended December 31,
(dollars in thousands, except per
share data) 2020 % Change 2019 % Change 2018
Operating income $ 338,157 (5.4) % $ 357,339 3.8 % $ 344,343
Total investment income 32,867 (17.8) 39,967 54.9 25,796
Interest expense, net 731 (14.7) 856 (65.2) 2,460
Other (expense) income (1,778) NM 255 (93.0) 3,641
Income before income taxes 368,515 (7.1) 396,705 6.8 371,320
Income tax expense 75,211 (5.8) 79,884 (3.9) 83,096
Net income $ 293,304 (7.4) % $ 316,821 9.9 % $ 288,224
Net income per share - diluted $ 5.61 (7.4) % $ 6.06 9.9 % $ 5.51
NM = not meaningful
Operating income decreased in 2020 compared to 2019 as growth in operating
expenses outpaced the growth in operating revenues. 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
2020, 2019, and 2018. The direct and affiliated assumed premiums written by the
Exchange increased 1.7% to $7.6 billion in 2020 and 5.2% to $7.5 billion in
2019.
Cost of operations for policy issuance and renewal services increased 3.3% to
$1.6 billion in 2020 primarily due to higher commissions driven by direct and
affiliated assumed written premium growth, higher agent incentive compensation
driven by lower automobile claims frequency experienced by the Exchange, and
higher personnel costs. Cost of operations for policy issuance and renewal
services increased 5.5% to $1.5 billion in 2019 driven primarily by higher
commissions and higher investments in information technology, partially offset
by lower agent and employee incentive costs related to less profitable growth on
the property and casualty insurance business of the Exchange.
Management fee revenue for administrative services increased 4.0% to $59.5
million in 2020 compared to 6.7% to $57.2 million in 2019. The administrative
services reimbursement revenue and corresponding cost of operations increased
both total operating revenue and total operating expenses to $609.4 million in
2020 and $582.0 million in 2019, but had no net impact on operating income.
Total investment income decreased $7.1 million in 2020 primarily driven by
higher impairments and lower net investment income reflecting lower interest
rates due to market volatility caused by the COVID-19 pandemic. Total investment
income increased $14.2 million in 2019 primarily driven by net realized
investment gains and higher net investment income.
Income tax expense was $75.2 million in 2020 compared to $79.9 million in 2019.
Income tax expense was reduced in 2019 by $4.0 million as a result of settling
an uncertain tax position, which decreased our effective tax rate by 1.0%.
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 I, 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 and equity security 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 degree of certainty at this time given the ongoing
developments of this pandemic and the related impacts on the financial markets.
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CRITICAL ACCOUNTING ESTIMATES
The financial statements include amounts based upon estimates and assumptions
that have a significant effect on reported amounts of assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period and related disclosures. We consider an
accounting estimate to be critical if 1) it requires assumptions to be made that
were uncertain at the time the estimate was made, and 2) different estimates
that could have been used, or changes in the estimate that are likely to occur
from period-to-period, could have a material impact on our Statements of
Operations or Financial Position.
The following presents a discussion of those accounting policies surrounding
estimates that we believe are the most critical to our reported amounts and
require the most subjective and complex judgment. If actual events differ
significantly from the underlying assumptions, there could be material
adjustments to prior estimates that could potentially adversely affect our
results of operations, financial condition, and cash flows. The estimates and
the estimating methods used are reviewed continually, and any adjustments
considered necessary are reflected in current earnings.
Investment Valuation
Available-for-sale securities
We make estimates concerning the valuation of all investments. Valuation
techniques are used to derive the fair value of the available-for-sale
securities we hold. Fair value is the price that would be received to sell an
asset in an orderly transaction between willing market participants at the
measurement date.
Fair value measurements are based upon observable and unobservable inputs.
Observable inputs reflect market data obtained from independent sources, while
unobservable inputs reflect our view of market assumptions in the absence of
observable market information. We utilize valuation techniques that maximize the
use of observable inputs and minimize the use of unobservable inputs.
For purposes of determining whether the market is active or inactive, the classification of a financial instrument is based upon the following definitions:
•An active market is one in which transactions for the assets being valued occur with sufficient frequency and volume to provide reliable pricing information.
•An inactive (illiquid) market is one in which there are few and infrequent transactions, where the prices are not current, price quotations vary substantially, and/or there is little information publicly available for the asset being valued.
We continually assess whether or not an active market exists for all of our investments and as of each reporting date re-evaluate the classification in the fair value hierarchy. All assets carried at fair value are classified and disclosed in one of the following three categories:
•Level 1 - Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity can access at the measurement date.
•Level 2 - Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.
•Level 3 - Unobservable inputs for the asset or liability.
Level 1 reflects market data obtained from independent sources, such as prices obtained from an exchange or a nationally recognized pricing service for identical instruments in active markets and primarily includes preferred stock.
Level 2 includes those financial instruments that are valued using
industry-standard models that consider various inputs, such as the interest rate
and credit spread for the underlying financial instruments. All significant
inputs are observable, or derived from observable information in the
marketplace, or are supported by observable levels at which transactions are
executed in the marketplace. Financial instruments in this category primarily
include corporate bonds, structured securities and preferred stock.
Level 3 securities are valued based upon unobservable inputs, reflecting our
estimates of value based upon assumptions used by market participants.
Securities are also assigned to Level 3 in cases where non-binding broker quotes
are significant to the valuation and there is a lack of transparency as to
whether these quotes are based upon information that is observable in the
marketplace. Fair value estimates for securities valued using unobservable
inputs require significant judgment due to the
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illiquid nature of the market for these securities and represent the best
estimate of the fair value that would occur in an orderly transaction between
willing market participants at the measurement date under current market
conditions. Fair value for these securities is generally valued using an
estimate of fair value based upon indicative market prices that include
significant unobservable inputs not based upon, nor corroborated by, market
information, including the utilization of discounted cash flow analyses which
have been risk-adjusted to take into account illiquidity and other market
factors. This category primarily consists of structured securities and corporate
bonds.
As of each reporting period, financial instruments recorded at fair value are
classified based upon the lowest level of input that is significant to the fair
value measurement. The presence of at least one unobservable input that has
significant impact to the fair value measurement would result in classification
as a Level 3 instrument. Our assessment of the significance of a particular
input to the fair value measurement requires judgment, and considers factors
specific to the asset, such as the relative impact on the fair value as a result
of including a particular input and market conditions. We did not make any other
significant judgments except as described above.
Estimates of fair values for our investment portfolio are obtained primarily
from a nationally recognized pricing service. Our Level 1 securities are valued
using an exchange traded price provided by the pricing service. Pricing service
valuations for Level 2 securities include multiple verifiable, observable inputs
including benchmark yields, reported trades, broker/dealer quotes, issuer
spreads, two-sided markets, benchmark securities, bids, offers, and reference
data. Pricing service valuations for Level 3 securities are based upon
proprietary models and are used when observable inputs are not available or in
illiquid markets.
Although virtually all of our prices are obtained from third party sources, we
also perform internal pricing reviews, including evaluating the methodology and
inputs used to ensure that we determine the proper classification level of the
financial instrument and reviewing securities with price changes that vary
significantly from current market conditions or independent price sources. Price
variances are investigated and corroborated by market data and transaction
volumes. We have reviewed the pricing methodologies of our pricing service as
well as other observable inputs and believe that the prices adequately consider
market activity in determining fair value.
In limited circumstances we adjust the price received from the pricing service
when, in our judgment, a better reflection of fair value is available based upon
corroborating information and our knowledge and monitoring of market conditions
such as a disparity in price of comparable securities and/or non-binding broker
quotes. In other circumstances, certain securities are internally priced because
prices are not provided by the pricing service.
When a price from the pricing service is not available, values are determined by
obtaining broker/dealer quotes and/or market comparables. When available, we
obtain multiple quotes for the same security. The ultimate value for these
securities is determined based upon our best estimate of fair value using
corroborating market information. As of December 31, 2020 , nearly all of our
available-for-sale and equity securities were priced using a third party pricing
service.
Impairments
Available-for-sale securities in an unrealized loss position are evaluated to
determine whether the impairment is a result of credit loss or other factors. If
we have the intent to sell or it's more likely than not that we would be
required to sell the security before recovery of the amortized cost basis, the
entire impairment is recognized in earnings. Securities that have experienced a
decline in fair value that we do not intend to sell, and that we will not be
required to sell before recovery, are evaluated to determine if the decline in
fair value is credit related. Impairment resulting from a credit loss is
recognized in earnings with a corresponding allowance on the balance sheet.
Future recoveries of credit loss result in an adjustment to the allowance and
earnings in the period the credit conditions improve. Factors considered in the
evaluation of credit loss include the extent to which fair value is less than
cost and fundamental factors specific to the issuer such as financial condition,
changes in credit ratings, near and long-term business prospects and other
factors, as well as the likelihood of recovery of the amortized cost of the
security. If the qualitative review indicates credit impairment, the allowance
for credit loss is measured as the amount that the security's amortized cost
exceeds the present value of cash flows expected to be collected and is limited
to the amount that fair value is below amortized cost.
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Retirement Benefit Plans for Employees
Our pension plans consist of a noncontributory defined benefit pension plan
covering substantially all employees and an unfunded supplemental employee
retirement plan ("SERP") for certain members of executive and senior management.
Although we are the sponsor of these postretirement plans and record the funded
status of these plans, the Exchange and its subsidiaries reimburse us for
approximately 59% of the annual benefit expense of these plans, which includes
pension benefits for employees performing administrative services and the
Exchange's allocated share of costs for employees in departments that support
the administrative functions.
Our pension obligation is developed from actuarial estimates. Several
statistical and other factors, which attempt to anticipate future events, are
used in calculating the expense and liability related to the plans. Key factors
include assumptions about the discount rates and expected rates of return on
plan assets. We review these assumptions annually and modify them considering
historical experience, current market conditions, including changes in
investment returns and interest rates, and expected future trends.
Accumulated and projected benefit obligations are expressed as the present value
of future cash payments. We discount those cash payments based upon a yield
curve developed from corporate bond yield information with maturities that
correspond to the payment of benefits. Lower discount rates increase present
values and subsequent year pension expense, while higher discount rates decrease
present values and subsequent year pension expense. The construction of the
yield curve is based upon yields of corporate bonds rated AA or equivalent
quality. Target yields are developed from bonds at various maturity points and
a curve is fitted to those targets. Spot rates (zero coupon bond yields) are
developed from the yield curve and used to discount benefit payment amounts
associated with each future year. The present value of plan benefits is
calculated by applying the spot/discount rates to projected benefit cash flows.
A single discount rate is then developed to produce the same present value. The
cash flows from the yield curve were matched against our projected benefit
payments in the pension plan, which have a duration of about 19 years. This
yield curve supported the selection of a 2.96% discount rate for the projected
benefit obligation at December 31, 2020 and for the 2021 pension expense. The
same methodology was used to develop the 3.59% and 4.47% discount rates used to
determine the projected benefit obligation for 2019 and 2018, respectively, and
the pension expense for 2020 and 2019, respectively. A 25 basis point decrease
in the discount rate assumption, with other assumptions held constant, would
increase pension cost in the following year by $6.8 million , of which our share
would be approximately $2.8 million , and would increase the pension benefit
obligation by $61.6 million .
Unrecognized actuarial gains and losses arise from several factors, including
experience and assumption changes in the obligations and from the difference
between expected returns and actual returns on plan assets. These unrecognized
gains and losses are recorded in the pension plan obligation and accumulated
other comprehensive income (loss). These amounts are systematically recognized
to net periodic pension expense in future periods, with gains decreasing and
losses increasing future pension expense. If actuarial net gains or losses
exceed 5% of the greater of the projected benefit obligation and the
market-related value of plan assets, the excess is recognized through the net
periodic pension expense equally over the estimated service period of the
employee group, which is currently 14 years.
The expected long-term rate of return for the pension plan represents the
average rate of return to be earned on plan assets over the period the benefits
included in the benefit obligation are to be paid. To determine the expected
long-term rate of return assumption, we utilized models based upon rigorous
historical analysis and forward-looking views of the financial markets based
upon key factors such as historical returns for the asset class' applicable
indices, the correlations of the asset classes under various market conditions
and consensus views on future real economic growth and inflation. The expected
future return for each asset class is then combined by considering correlations
between asset classes and the volatilities of each asset class to produce a
reasonable range of asset return results within which our expected long-term
rate of return assumption falls. The expected long-term rate of return is less
susceptible to annual revisions, as there are typically no significant changes
in the asset mix. Based on the current asset allocation and a review of the key
factors and expectations of future asset performance, we reduced the expected
return on asset assumption from 6.00% to 5.50% for 2021. A change of 25 basis
points in the expected long-term rate of return assumption, with other
assumptions held constant, would have an estimated $2.3 million impact on net
pension benefit cost in the following year, of which our share would be
approximately $0.9 million .
We use a four-year averaging method to determine the market-related value of
plan assets, which is used to determine the expected return component of pension
expense. Under this methodology, asset gains or losses that result from returns
that differ from our long-term rate of return assumption are recognized in the
market-related value of assets on a level basis over a four-year period. The
market-related asset experience during 2020 that related to the actual
investment return being different from that assumed during the prior year was a
gain of $146.3 million . Recognition of this gain will be deferred and recognized
over a four-year period, consistent with the market-related asset value
methodology. Once factored into the market-related asset value, these experience
gains and losses will be amortized over a period of 14 years, which is the
remaining service period of the employee group.
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Estimates of fair values of the pension plan assets are obtained primarily from
the trustee and custodian of our pension plan. Our Level 1 category includes a
money market mutual fund and a separate account for which the fair value is
determined using an exchange traded price provided by the trustee and
custodian. Our Level 2 category includes commingled pools. Estimates of fair
values for securities held by our commingled pools are obtained primarily from
the trustee and custodian. Trustee and custodian valuation methodologies for
Level 2 securities include multiple verifiable, observable inputs including
benchmark yields, reported trades, broker/dealer quotes, issuers spreads,
two-sided markets, benchmark securities, bids, offers, and reference data. There
were no Level 3 investments in 2020 or 2019.
We expect our net pension benefit costs to increase from $45.1 million in 2020
to $56.6 million in 2021 primarily driven by the decrease in the discount rate.
Our share of the net pension benefit costs after reimbursements was $18.5
million in 2020. We expect our share of the net pension benefit costs to be
approximately $23.2 million in 2021.
The actuarial assumptions we used in determining our pension obligation may
differ materially from actual results due to changing market and economic
conditions, higher or lower withdrawal rates, or longer or shorter life spans of
participants. While we believe that the assumptions used are appropriate,
differences in actual experience or changes in assumptions may materially affect
our financial position, results of operations, or cash flows. See Item 8.
"Financial Statements and Supplementary Data - Note 10, Postretirement Benefits,
of Notes to Financial Statements" contained within this report for additional
details on the pension plans.
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-------------------------------------------------------------------------------- Table of Contents 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. Our revenues are allocated between the two performance obligations. Management fee rate 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 2020, 2019 and 2018. Changes in the management fee rate can affect our revenue and net income significantly. The transaction price for 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 reviewed the transaction price allocation quarterly to consider the most current economic conditions related to the COVID-19 pandemic. The reviews resulted in no material change to the allocation.
The following table presents the allocation and disaggregation of revenue for our two performance obligations:
Years ended December 31,
(dollars in thousands) 2020 % Change 2019 % Change 2018
Policy issuance and renewal services
Direct and affiliated assumed premiums
written by the Exchange $ 7,613,519 1.7 % $ 7,486,030 5.2 % $ 7,112,846
Management fee rate 24.2 % 24.2 % 24.2 %
Management fee revenue 1,842,472 1.7 1,811,619 5.2 1,721,309
Change in allowance for management fee returned on cancelled policies (1) (678) 41.7 (1,162) 33.3
(1,742)
Management fee revenue - policy issuance and renewal services, net$ 1,841,794 1.7 %$ 1,810,457 5.3 % $
1,719,567
Administrative services Direct and affiliated assumed premiums written by the Exchange$ 7,613,519 1.7 %$ 7,486,030 5.2 %$ 7,112,846 Management fee rate 0.8 % 0.8 % 0.8 % Management fee revenue 60,908 1.7 59,888 5.2 56,903 Change in contract liability (2) (1,376) 47.8 (2,633) 17.9
(3,209)
Change in allowance for management fee returned on cancelled policies (1) (69) (34.6) (51) 17.0
(62)
Management fee revenue - administrative services, net 59,463 4.0 57,204 6.7
53,632
Administrative services reimbursement revenue 609,435 4.7 582,010 0.3
580,336
Total revenue from administrative services$ 668,898 4.6 %$ 639,214 0.8 %$ 633,968 (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. The potential for a greater number of mid-term cancellations as a result of the COVID-19 pandemic was taken into consideration in the determination of this allowance in 2020. (2) Management fee revenue - administrative services is recognized over time as the services are performed. See Item 8. "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 1.7% to$7.6 billion in 2020, from$7.5 billion in 2019, driven by an increase in policies in force. Year-over-year policies in force for all lines of business increased 2.1% in 2020 as the result of continuing strong policyholder retention, compared to 1.8% in 2019. The year-over-year average premium per policy for all lines of business decreased 0.4% atDecember 31, 2020 , compared to an increase of 3.2% atDecember 31, 2019 . The year-over-year average premium per policy atDecember 31, 2020 was impacted by the rate reductions for personal and commercial auto policies as a result of the COVID-19 pandemic. Premiums generated from new business decreased 1.2% to$852 million in 2020. While new business policies written increased 5.0 % in 2020, year-over-year average premium per policy on new business decreased 5.9% atDecember 31, 2020 , driven by the personal and commercial auto rate reductions which took effect in the third quarter of 2020. Premiums generated from new business decreased 2.6% to$863 million in 2019. While year-over-year average premium per policy on new business increased 5.1% atDecember 31, 2019 , new business policies written decreased 7.4% in 2019. Premiums generated from renewal business increased 2.1% to$6.8 billion in 2020, compared to 6.4%, or$6.6 billion , in 2019. Underlying the trend in renewal business premiums were increases in average premium per policy and steady policy retention ratios. The renewal business year-over-year average premium per policy increased 0.4% atDecember 31, 2020 , compared to 2.9% atDecember 31, 2019 . The Exchange implements rate changes in order to meet loss cost expectations. As the Exchange writes policies with annual terms only, rate actions take 12 months to be fully recognized in written premium and 24 months to be recognized in earned premiums. Since rate changes are realized at renewal, it takes 12 months to implement a rate change to all policyholders and another 12 months to earn the increased or decreased premiums in full. As a result, certain rate changes approved in 2019 were reflected in 2020, and a portion of the rate actions in 2020, primarily those in response to reduced driving conditions resulting from the COVID-19 pandemic, will be reflected in 2021. The Exchange continuously evaluates pricing and product offerings to meet consumer demands. Personal lines - Total personal lines premiums written increased 1.3% to$5.4 billion in 2020, from$5.3 billion in 2019, driven by an increase in total personal lines policies in force of 2.2%. While the impacts of the COVID-19 pandemic, including changes in consumer behavior and driving patterns, among others, significantly reduced new personal policies written in the second quarter of 2020, new personal policies written increased 20.7% in the second half of 2020, compared to the same period last year. Total personal lines year-over-year average premium per policy decreased 0.8% atDecember 31, 2020 , compared to the prior year, driven by personal auto rate reductions. Total personal lines policies in force increased 1.8% in 2019 and year-over-year average premium per policy increased 2.9% atDecember 31, 2019 . Commercial lines - Total commercial lines premiums written increased 2.6% to$2.2 billion in 2020, compared to 2019, driven by a 1.6% increase in total commercial lines policies in force and a 0.9% increase in the total commercial lines year-over-year average premium per policy. While there was a significant reduction in new commercial policies written in the second quarter of 2020 as a result of the business disruptions and unfavorable economic conditions related to the COVID-19 pandemic, new commercial policies written increased 2.4% in the second half of 2020 compared to the same period last year. The second half of 2020 activity was primarily driven by an increase in commercial auto policies written which was partially offset by a decrease in workers compensation policies written. Total commercial lines premiums written increased 6.1% in 2019, compared to 2018, driven by a 2.4% increase in total commercial lines policies in force and a 3.6% increase in the total commercial lines year-over-year average premium per policy. Future trends-premium revenue - 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. Changes in premium levels attributable to the growth in policies in force directly affect the profitability of the Exchange and have a direct bearing on our management fee. Our continued focus on underwriting discipline and the maturing of pricing sophistication models have contributed to the Exchange's steady policy retention ratios. The continued growth of its policy base is dependent upon the Exchange's ability to retain existing and attract new subscribers/policyholders. A lack of new policy growth or the inability to retain existing customers could have an adverse effect on the Exchange's premium level growth, and consequently our management fee. 30 -------------------------------------------------------------------------------- Table of Contents Changes in premium levels attributable to rate changes also directly affect the profitability of the Exchange and have a direct bearing on our management fee. Pricing actions contemplated or taken by the Exchange are subject to various regulatory requirements of the states in which it operates. The pricing actions already implemented, or to be implemented, have an effect on the market competitiveness of the Exchange's insurance products. Such pricing actions, and those of the Exchange's competitors, could affect the ability of the Exchange's agents to retain and attract new business; additionally, exposure reductions and/or changes in mix of business as a result of economic conditions could impact the average premium written and affiliated assumed by the Exchange, as customers may reduce coverages. 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. The remaining rate reductions implemented for personal and commercial auto policies in response to the COVID-19 pandemic are estimated to decrease premiums by$110 million with a corresponding decrease of$28 million in management fee revenue in 2021. Future premiums could also be impacted by potential regulatory changes resulting from the COVID-19 pandemic.
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 I, Item 1A. "Risk Factors" contained within this report.
31
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Table of Contents
Policy issuance and renewal services
Years ended December 31,
(dollars in thousands) 2020 % Change 2019 % Change 2018
Management fee revenue - policy issuance and
renewal services, net $ 1,841,794 1.7 % $ 1,810,457 5.3 % $ 1,719,567
Service agreement revenue 25,797 (6.6) 27,627 (3.7) 28,677
1,867,591 1.6 1,838,084 5.1 1,748,244
Cost of policy issuance and renewal services 1,588,897 3.3 1,537,949 5.5
1,457,533
Operating income - policy issuance and renewal services$ 278,694 (7.1) %$ 300,135 3.2 %$ 290,711 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 affiliated 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 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
Years ended December 31,
(dollars in thousands) 2020 % Change 2019 % Change 2018
Commissions:
Total commissions $ 1,051,272 2.6 % $ 1,024,654 4.2 % $ 983,758
Non-commission expense:
Underwriting and policy processing $ 160,646 3.7 % $ 154,934 3.8 % $ 149,234
Information technology 173,827 3.7 167,600 16.0 144,495
Sales and advertising 53,212 1.6 52,362 (5.8) 55,608
Customer service 34,638 7.1 32,353 9.9 29,447
Administrative and other 115,302 8.7 106,046 11.6 94,991
Total non-commission expense 537,625 4.7 513,295 8.3 473,775
Total cost of policy issuance and renewal services$ 1,588,897 3.3 %$ 1,537,949 5.5 %$ 1,457,533 Commissions - Commissions increased$26.6 million in 2020 compared to 2019 resulting from higher direct and affiliated assumed premiums written by the Exchange and higher agent incentive compensation. The Exchange experienced a significant decrease in automobile claims frequency and related loss expense beginning inMarch 2020 that continued throughMay 2020 driven by the COVID-19 pandemic, which contributed to an increase in the profitability component of the agent incentive bonuses. Claims frequency increased inJune 2020 and maintained consistent levels through the remainder of 2020. Commissions increased$40.9 million in 2019 compared to 2018 resulting from higher direct and affiliated assumed premiums written by the Exchange, somewhat offset by lower agent incentive costs related to less profitable growth. Non-commission expense - Non-commission expense increased$24.3 million in 2020 compared to 2019. Underwriting and policy processing costs increased$5.7 million primarily due to increased personnel costs and underwriting report costs. Information technology costs increased$6.2 million primarily due to increased personnel costs and hardware and software costs. Administrative and other expenses increased$9.3 million primarily driven by increased personnel costs. Increased personnel costs in all categories included higher incentive plan award accruals related to underwriting performance in 2020 32 -------------------------------------------------------------------------------- Table of Contents compared to targets and higher vacation accruals as employees took less vacation in 2020 as a result of the COVID-19 pandemic. In 2019, non-commission expense increased$39.5 million compared to 2018. Underwriting and policy processing costs increased$5.7 million primarily due to increased underwriting report costs and other policy acquisition costs. Information technology costs increased$23.1 million primarily due to increased professional fees and hardware and software costs. Sales and advertising costs decreased$3.2 million due to decreased personnel costs. Customer service costs increased$2.9 million primarily due to increased credit card processing fees and personnel costs. Administrative and other expenses increased$11.1 million primarily driven by an increase in the long-term incentive plan costs due to a higher company stock price in 2019 compared to 2018 and several multi-year commitments made to support community development initiatives. Personnel costs in all expense categories were impacted by increased medical expenses, somewhat offset by lower estimated costs for incentive plans related to sales and underwriting performance in 2019 compared to targets.
Administrative services
Years ended December 31,
(dollars in thousands) 2020 % Change 2019 % Change 2018
Management fee revenue - administrative
services, net $ 59,463 4.0 % $ 57,204 6.7 % $ 53,632
Administrative services reimbursement
revenue 609,435 4.7 582,010 0.3 580,336
Total revenue allocated to administrative
services 668,898 4.6 639,214 0.8 633,968
Administrative services expenses
Claims handling services 525,072 3.7 506,491 0.1 505,843
Investment management services 36,835 9.5 33,640 4.9 32,065
Life management services 47,528 13.5 41,879 (1.3) 42,428
Operating income - administrative services $ 59,463 4.0 % $ 57,204 6.7 % $ 53,632
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.
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.
33
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Table of Contents
Total investment income
A summary of the results of our investment operations is as follows for the
years ended December 31 :
(dollars in thousands) 2020 % Change 2019 % Change 2018
Net investment income $ 29,753 (12.6) % $ 34,059 15.9 % $ 29,387
Net realized investment gains
(losses) 6,392 4.7 6,103 NM (2,010)
Net impairment losses recognized in
earnings (3,278) NM (195) NM (1,581)
Total investment income $ 32,867 (17.8) % $ 39,967 54.9 % $ 25,796
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 $4.3 million in 2020, compared to 2019, primarily
due to decreased income from cash and cash equivalents driven by lower rates and
invested balances, somewhat offset by increased preferred stock income resulting
from higher invested balances. Net investment income increased by $4.7 million
in 2019, compared to 2018, primarily due to an increase in cash and cash
equivalent and agent loan interest income reflecting higher invested balances
and rates, somewhat offset by decreased income on fixed maturities due to lower
invested balances and yields.
Net realized investment gains (losses)
A breakdown of our net realized investment gains (losses) is as follows for the
years ended December 31 :
(in thousands) 2020 2019 2018
Securities sold:
Available-for-sale securities $ 1,335 $ 4,619 $ (1,297)
Equity securities (713) (1) (111)
Equity securities change in fair value 5,769 1,485 (708)
Miscellaneous 1 -
106
Net realized investment gains (losses)
Net realized gains of$6.4 million in 2020 were primarily due market value adjustments on equity securities and from the sale of available-for-sale securities. Net realized gains of$6.1 million in 2019 were primarily due to gains from sales of available-for-sale securities and increases in fair value of equity securities, while losses of$2.0 million in 2018 were due to losses from sales of available-for-sale and equity securities and decreases in fair value of equity securities. Net impairment losses recognized in earnings Net impairment losses recognized on available-for-sale securities in 2020 include$2.3 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 2020 compared to prior years. Net impairment losses recognized in 2019 and 2018 included securities in an unrealized loss position that we intended to sell prior to expected recovery of our amortized cost basis as well as securities in an unrealized loss position where we determined the loss was other-than-temporary based on credit factors. 34
-------------------------------------------------------------------------------- Table of Contents Financial Condition of Erie 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 meet obligations to policyholders over the long term. OnJuly 8, 2020 , the outlook for the financial strength rating was affirmed as stable. As ofDecember 31, 2020 , only approximately 12% of insurance groups, in which the Exchange is included, are rated A+ or higher. 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 1.7% to$7.6 billion in 2020 from$7.5 billion in 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$10.7 billion and$9.5 billion atDecember 31, 2020 and 2019, respectively. The Exchange and its wholly owned property and casualty subsidiaries' year-over-year policy retention ratio continues to be high at 89.9% atDecember 31, 2020 and 90.0% atDecember 31, 2019 . We have prepared our financial statements considering the financial strength of the Exchange based on itsA.M. 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 established risk tolerances. However, see Part I, Item 1A. "Risk Factors" for possible outcomes that could impact that determination. 35
-------------------------------------------------------------------------------- Table of Contents FINANCIAL CONDITION
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) % to % to
2020 total 2019 total
Fixed maturities $ 928,236 84 % $ 730,701 82 %
Equity securities:
Preferred stock 94,071 9 64,752 7
Common stock 19 0 2,381 0
Agent Loans (1) 69,212 6 67,696 8
Other investments 14,325 1 28,205 3
Total investments $ 1,105,863 100 % $ 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.
We continually review our investment portfolio for impairment and determine whether the impairment is a result of credit loss or other factors. We individually analyze all positions with an emphasis on those in a significant unrealized loss position. If we have the intent to sell or it's more likely than not that we would be required to sell the security before recovery of the amortized cost basis, the entire impairment is recognized in earnings. Factors considered in the evaluation of credit loss include the extent to which fair value is less than cost and fundamental factors specific to the issuer such as financial condition, changes in credit ratings, near and long-term business prospects and other factors, as well as the likelihood of recovery of the amortized cost of the security. Impairment resulting from credit loss is recognized in earnings with a corresponding allowance on the balance sheet. We believe our investment valuation philosophy and accounting practices result in appropriate and timely measurement of fair value and recognition of impairment. 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$23.3 million atDecember 31, 2020 , compared to net unrealized gains of$4.5 million atDecember 31, 2019 . The following table presents a breakdown of the fair value of our fixed maturity portfolio by industry sector and rating as ofDecember 31, 2020 : (1) (in thousands) Non-investment Fair AAA AA A BBB grade value Basic materials$ 0 $ 0 $ 3,277 $ 4,053 $ 8,911$ 16,241 Communications 0 8,932 8,661 22,451 18,973 59,017 Consumer 0 3,246 25,221 66,057 43,391 137,915 Diversified 0 0 0 1,072 423 1,495 Energy 0 7,548 4,701 18,288 11,424 41,961 Financial 0 1,035 59,632 117,261 12,393 190,321 Industrial 0 0 10,220 14,851 18,465 43,536 Structured securities (2) 146,270 168,083 34,018 13,439 0 361,810 Technology 0 5,311 12,308 18,448 11,388 47,455 Utilities 0 0 3,945 18,997 5,543 28,485 Total$ 146,270 $ 194,155 $ 161,983 $ 294,917 $ 130,911 $ 928,236 (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. 36 -------------------------------------------------------------------------------- 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 ofDecember 31 : (in thousands) 2020 2019 Common Common Preferred Stock stock Preferred Stock stock Communications $ 2,699$ 0 $ 1,052$ 2,381 Consumer 3,068 0 508 0 Energy 2,187 19 1,881 0 Financial services 76,575 0 53,513 0 Industrial 800 0 980 0 Utilities 8,742 0 6,818 0 Total $ 94,071$ 19 $ 64,752$ 2,381 Shareholders' Equity Postretirement benefit plans The funded status of our postretirement benefit plans is recognized in the Statements of Financial Position, with a corresponding adjustment to accumulated other comprehensive income (loss), net of tax. AtDecember 31, 2020 , shareholders' equity amounts related to these postretirement plans increased by$20.0 million , net of tax, of which$10.6 million represents amortization of the prior service cost and net actuarial loss and$9.4 million represents the current period actuarial gain. The actuarial gain was driven by higher than expected returns on assets which exceeded losses incurred as a result of the lower discount rate in 2020. AtDecember 31, 2019 , shareholders' equity amounts related to these postretirement plans increased by$1.7 million , net of tax, of which$4.9 million represents amortization of the prior service cost and net actuarial loss offset by$3.2 million of current period actuarial loss. The 2019 actuarial loss was primarily due to the change in the discount rate assumption used to measure the future benefit obligations to 3.59% in 2019, from 4.47% in 2018. Although we are the sponsor of these postretirement plans and record the funded status of these plans, the Exchange and its subsidiaries reimburse us for approximately 59% of the annual benefit expense of these plans, which includes pension benefits for employees performing administrative services and their allocated share of costs for employees in departments that support the administrative functions. Home Office Expansion In 2016, we entered into a credit agreement for a$100 million senior secured draw term loan credit facility ("Credit Facility") for the acquisition of real property and construction of an office building that will serve as part of our principal headquarters. OnJanuary 1, 2019 , the Credit Facility converted to a fully-amortized term loan with monthly payments of principal and interest at a fixed rate of 4.35% over a period of 28 years. We capitalized applicable interest charges incurred during the construction period of long-term building projects as part of the historical cost of the asset. The building was completed in the fourth quarter of 2020. 37 -------------------------------------------------------------------------------- Table of Contents LIQUIDITY AND CAPITAL RESOURCES While we did not see a significant impact on our sources or uses of cash in 2020 as a result of the COVID-19 pandemic, 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. Accordingly, we continue to monitor the sufficiency of our liquidity and capital resources given the potential impact of the COVID-19 pandemic. 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 I, 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 of our 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 2021 and beyond. Cash flow activities The following table provides condensed cash flow information for the years endedDecember 31 : (in thousands) 2020 2019
2018
Net cash provided by operating activities
$ 263,585 Net cash used in investing activities (243,225) (124,634)
(81,398)
Net cash used in financing activities (274,869) (169,571)
(131,491)
Net (decrease) increase in cash$ (175,499) $ 70,322 $ 50,696 Net cash provided by operating activities was$342.6 million in 2020, compared to$364.5 million in 2019 and$263.6 million in 2018. Decreased cash provided by operating activities in 2020 was primarily due to an increase in cash paid for agent commissions of$33.3 million due to higher scheduled commissions driven by premium growth, increased general operating expenses paid of$17.4 million and increased administrative services expenses paid of$16.2 million . Offsetting the decrease in cash provided by operating activities was an increase of$42.5 million in management fee received driven by growth in direct and affiliated assumed premiums written by the Exchange, compared to 2019. Increased cash provided by operating activities in 2019 was primarily due to an increase of$93.8 million in management fee revenue received driven by growth in direct and affiliated assumed premiums written by the Exchange and a decrease in pension contributions and employee benefits paid of$72.8 million , driven by the$80 million accelerated pension contribution in 2018. Offsetting the increase in cash provided by operating activities was increased cash paid for agent commissions of$41.8 million due to higher scheduled commissions driven by premium growth, compared to 2018. Net cash used in investing activities totaled$243.2 million in 2020, compared to$124.6 million in 2019 and$81.4 million in 2018. Net cash used in investing activities increased in 2020 as purchases of available-for-sale securities exceeded the proceeds generated from investment sales and maturities/calls of available-for-sale securities. Fixed asset purchases decreased$46.5 million in 2020 compared to 2019 primarily due to the completion of the new home office building in the fourth quarter of 2020 which was funded primarily by the senior secured draw term loan credit facility. In 2019, we generated more proceeds from investment activity, which were offset by higher purchases of available-for-sale securities and equity securities due to portfolio rebalancing. Fixed asset purchases also increased primarily related to the new home office building. Net cash used in financing activities totaled$274.9 million in 2020, compared to$169.6 million in 2019 and$131.5 million in 2018. The increase in cash used in 2020, compared to 2019, was due to an increase in dividends paid to shareholders. In 38 -------------------------------------------------------------------------------- Table of Contents addition to the normal quarterly dividends paid in 2020, the Board also declared a special one-time cash dividend of$2.00 on each Class A share and$300 on each Class B share totaling$93.1 million , which was paid inDecember 2020 . The increase in cash used in 2019, compared to 2018, was due to an increase in dividends paid to shareholders and principal payments on the senior secured draw term loan credit facility, which commencedJanuary 1, 2019 . No shares of our Class A nonvoting common stock were repurchased in 2020, 2019 and 2018 in conjunction with our stock repurchase program. In 2011, our Board of Directors approved a continuation of the current stock repurchase program for a total 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 atDecember 31, 2020 , based upon trade date. We purchase shares of our outstanding Class A nonvoting common stock outside of our publicly announced share repurchase program for certain stock-based incentive plans. We purchased 31,248 shares for$5.8 million in 2020, 15,003 shares for$2.6 million in 2019 and 27,120 shares for$3.2 million in 2018 to settle awards for our equity compensation plan and to fund the rabbi trust for the outside director deferred stock compensation plan and the incentive compensation deferral plan. All shares were delivered in the year they were purchased. 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$161.2 million atDecember 31, 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$646.4 million atDecember 31, 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 ofDecember 31, 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 ofDecember 31, 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 ofDecember 31, 2020 . Investments with a fair value of$124.9 million were pledged as collateral on the line atDecember 31, 2020 . These securities have no trading restrictions and are reported as available-for-sale securities and cash and cash equivalents in the Statements of Financial Position. The bank requires compliance with certain covenants, which include leverage ratios and debt restrictions. We were in compliance with our bank covenants atDecember 31, 2020 . 39 -------------------------------------------------------------------------------- Table of Contents Contractual Obligations We have certain obligations and commitments to make future payments under various contracts. As ofDecember 31, 2020 , the aggregate obligations were as follows: Payments due by period 2026 and (in thousands) Total 2021 2022-2023 2024-2025 thereafter Long-term debt (1)$ 160,648 $ 6,183 $ 12,366 $ 12,366 $ 129,733 Home office expansion (2) 13,556 13,556 0 0 0 Operating leases (3) 14,537 10,817 3,452 89 179 Other commitments (4) 385,707 244,638 125,434 14,977 658 Gross contractual obligations (5) 574,448 275,194 141,252 27,432 130,570 Estimated reimbursements from affiliates (6) 114,293 68,694 38,891 6,318 390 Net contractual obligations$ 460,155 $ 206,500 $ 102,361 $ 21,114 $ 130,180
(1) Long-term debt amount differs from the balance presented on the Statements of Financial Position as the amount in the table above includes interest and principal payments.
(2) We agreed to the guaranteed maximum price terms of an agreement with our construction manager for the construction of the office building that will serve as part of our principal headquarters. The building was completed in the fourth quarter of 2020. Commitments due in 2021 represent settlement of final construction costs. This project is primarily being funded by the senior secured draw term loan credit facility included in long-term debt in the table above. Included in these amounts are obligations for furniture and fixtures and information technology costs for the office building. (3) Operating leases represent the total commitment for the lease components of our operating lease agreements. Non-lease component commitments related to these contracts are included in other commitments. See Item 8. "Financial Statements and Supplementary Data - Note 2, Significant Accounting Policies and Note 8, Leases, of Notes to Financial Statements" contained within this report. (4) Other commitments include various agreements for services, including information technology, support, and maintenance obligations, and other obligations in the ordinary course of business. These agreements are enforceable and legally binding and specify fixed or minimum quantities to be purchased and the approximate timing of the transaction. The table above also includes agreements that contain cancellation provisions, some of which may require us to pay a termination fee. The amounts under such contracts are included in the table above as we expect to make future cash payments according to the contract terms. (5) The obligation for our unfunded Supplemental Employee Retirement Plan (SERP) for our executive and senior management is not included in gross contractual obligations. The accumulated benefit obligation for this plan atDecember 31, 2020 is$26.5 million . We expect to have sufficient cash flows from operations to meet the future benefit payments as these become due.
(6) We are reimbursed from the Exchange and its subsidiaries for a portion of the costs related to other commitments and operating leases.
Our funding policy for our defined benefit pension plan is generally to contribute an amount equal to the greater of the target normal cost for the plan year, or the amount necessary to fund the plan to 100%. Historically, this has resulted in an annual pension contribution. In 2018, however, we made accelerated pension contributions totaling$80 million . Following our 2018 contribution, we would not expect to make a subsequent contribution until the sum of the target normal costs for plan years beginning on and afterDecember 31, 2017 exceeds$80 million , or earlier if a contribution is necessary to fund the plan to 100%. Off-Balance Sheet Arrangements 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. Enterprise Risk Management The role of our Enterprise Risk Management ("ERM") function is to ensure that all significant risks are clearly identified, understood, proactively managed and consistently monitored to achieve strategic objectives for all stakeholders. Our ERM program views risk holistically across our entire group of companies. It ensures implementation of risk responses to mitigate potential impacts. See Part I, Item 1A. "Risk Factors" contained in this report for a list of risk factors. Our ERM process is founded on a governance framework that includes oversight at multiple levels of our organization, including our Board of Directors and executive management. Accountability to identify, manage, and mitigate risk is embedded within all functions and areas of our business. We have defined risk tolerances to monitor and manage significant risks within acceptable levels. In addition to identifying, evaluating, prioritizing, monitoring, and mitigating significant risks, our ERM process includes extreme event analyses and scenario testing. Given our defined tolerance for risk, risk model output is used to quantify the potential variability of future performance and the sufficiency of capital and liquidity levels. 40 -------------------------------------------------------------------------------- Table of Contents TRANSACTIONS/AGREEMENTS WITH RELATED PARTIES Board Oversight Our Board of Directors has a broad oversight responsibility over our intercompany relationships with the Exchange. As a consequence, our Board of Directors may be required to make decisions or take actions that may not be solely in the interest of our shareholders, such as setting the management fee rate paid by the Exchange to us and ratifying any other significant activity. Insurance Holding Company System Most states have enacted legislation that regulates insurance holding company systems, defined as two or more affiliated persons, one or more of which is an insurer. The Exchange has the following wholly owned property and casualty subsidiaries:Erie Insurance Company ,Erie Insurance Company of New York ,Erie Insurance Property & Casualty Company andFlagship City Insurance Company , and a wholly owned life insurance company,Erie Family Life Insurance Company . Indemnity and the Exchange, and its wholly owned subsidiaries, meet the definition of an insurance holding company system. All transactions within a holding company system affecting the member insurers of the holding company system must be fair and reasonable and any charges or fees for services performed must be reasonable. Approval by the applicable insurance commissioner is required prior to the consummation of transactions affecting the members within a holding company system. Intercompany Agreements Subscriber's and services agreements We serve as attorney-in-fact for the subscribers at the Exchange, a reciprocal insurance exchange. Each applicant for insurance to a reciprocal insurance exchange signs a subscriber's agreement that contains an appointment of an attorney-in-fact. Through the designation of attorney-in-fact, we are required to provide policy issuance and renewal services and act as the attorney-in-fact for the Exchange with respect to all administrative services, as discussed previously. Pursuant to the subscriber's agreement, we earn a management fee for these services calculated as a percentage of the direct and affiliated assumed premiums written by the Exchange. 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 the attorney-in-fact. The Exchange's insurance subsidiaries also utilize Indemnity for all administrative services in accordance with the service agreements between each of the subsidiaries and Indemnity. The amounts incurred for all administrative services are reimbursed to Indemnity at cost in accordance with the subscriber's agreement and the service agreements. These reimbursements are settled on a monthly basis. State insurance regulations require that intercompany service agreements and any material amendments be approved in advance by the state insurance department. Leased property We lease the home office from the Exchange. Rent is based on rental rates of like property inErie, Pennsylvania and all operating expenses including utilities, cleaning, repairs, real estate taxes, and property insurance are the responsibility of the tenant (Indemnity). Rental costs of shared facilities are allocated based upon usage or square footage occupied. We also had a lease commitment with EFL for a field office until 2018. We previously owned three field offices for which rental costs of shared facilities were allocated based upon usage or square footage occupied. In 2018, we sold the three field offices to the Exchange at the current independent appraised value in order to align the ownership interest of these facilities with the functions being performed at these locations, which are claims-related activities. Cost Allocation The allocation of costs affects our financial condition and that of the Exchange and its wholly owned subsidiaries. Management's role is to determine that allocations are consistently made in accordance with the subscriber's agreement with the subscribers at the Exchange, intercompany service agreements, and applicable insurance laws and regulations. Allocation of costs under these various agreements requires judgment and interpretation, and such allocations are performed using a consistent methodology, which is intended to adhere to the terms and intentions of the underlying agreements. Intercompany Receivables We have significant receivables from the Exchange and its affiliates that result in a concentration of credit risk. Net receivables from the Exchange and other affiliates were$494.6 million , or 23.4% of total assets, atDecember 31, 2020 and$468.6 million , or 23.2% of total assets, atDecember 31, 2019 . These receivables include management fees due for policy issuance and renewal services performed by us under the subscriber's agreement, and certain costs we incur acting as the attorney-in-fact on behalf of the Exchange as well as the service provider for its insurance subsidiaries with respect to all administrative services, 41
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Table of Contents as discussed previously. These receivables from the Exchange and its affiliates are settled monthly. We continually monitor the financial strength of the Exchange. Surplus Note We previously held a$25 million surplus note issued to us by EFL that was payable on demand on or afterDecember 31, 2018 . In 2018, EFL, with the appropriate approval from the Pennsylvania Insurance Commissioner, satisfied its obligation and repaid the surplus note. EFL paid related interest to us of$1.6 million in 2018.
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