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, 2020 , as contained in our Annual Report on Form 10-K filed with theSecurities and Exchange Commission onFebruary 25, 2021 . INDEX Page Number
Cautionary Statement Regarding Forward-Looking Information 23 Operating Overview 24 Results of Operations 27 Financial Condition 33 Liquidity and Capital Resources 35 Critical Accounting Estimates 37
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: •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; 23 -------------------------------------------------------------------------------- Table of Contents •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.
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 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.
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Coronavirus ("COVID-19") pandemic
In March 2020 , the outbreak of the coronavirus ("COVID-19") was declared a
global pandemic. The uncertainty resulting from the COVID-19 pandemic continues
to evolve and the pandemic's ultimate impact and duration remain 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. The uncertainty of the
ongoing impacts of the COVID-19 pandemic will likely continue until such time as
the spread of the virus is contained. In response to reduced driving conditions
in 2020 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. These rate reductions resulted in a decrease to
Exchange's written premiums of approximately $55 million and $110 million for
the three and six months ended June 30, 2021 , respectively, and a corresponding
decrease in our management fee revenue of approximately $14 million and $28
million for the three and six months ending June 30, 2021 , respectively. There
may also be other market and/or regulatory pressures that could impact the
Exchange's operations. While financial markets remained generally strong in the
first half of 2021, we could experience future losses and/or impairments to the
portfolio if future development of the pandemic impacts market conditions.
Additionally, we continued to incur increased agent incentive costs as claim
frequency, while increasing in 2021, remains lower than pre-pandemic levels
resulting in improved agent profitability the first half of 2021. 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 Financial Condition and
Liquidity and Capital Resources contained within this report, as well as Part I.
Item 1A. "Risk Factors" related to COVID-19 as included in our Annual Report on
Form 10-K for the fiscal year ended December 31, 2020 as filed with the
Securities and Exchange Commission on February 25, 2021 .
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 responsible for the development and implementation of a return to office
plan. Some employees began returning to our offices in July 2021 . Additional
employees will return to our offices in phases, assuming the pandemic does not
worsen.
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Financial Overview
Three months ended June 30, Six months ended June 30,
(dollars in thousands, except
per share data) 2021 2020 % Change 2021 2020 % Change
(Unaudited) (Unaudited)
Operating income $ 85,065 $ 91,189 (6.7) % $ 161,160 $ 176,880 (8.9) %
Total investment income 16,418 11,553 42.1 34,406 2,358 NM
Interest expense, net 1,039 2 NM 2,048 5 NM
Other expense 548 258 NM 1,067 624 71.0
Income before income taxes 99,896 102,482 (2.5) 192,451 178,609 7.8
Income tax expense 20,867 20,505 1.8 39,856 37,306 6.8
Net income $ 79,029 $ 81,977 (3.6) % $ 152,595 $ 141,303 8.0 %
Net income per share - diluted $ 1.51 $ 1.57 (3.6) % $ 2.92 $ 2.70 8.0 %
NM = not meaningful
Operating income decreased in both the second quarter and six months ended
June 30, 2021 , compared to the same periods in 2020, as growth in operating
expenses outpaced the growth in operating revenues. Management fee revenue for
policy issuance and renewal services increased 3.8% to $502.3 million in the
second quarter of 2021 and 3.3% to $958.0 million for the six months ended June
30, 2021 , 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 2021 and 2020. The direct and
affiliated assumed premiums written by the Exchange increased 3.4% to $2.1
billion in the second quarter of 2021 and increased 2.6% to $3.9 billion for the
six months ended June 30, 2021 compared to the same periods in 2020.
Cost of operations for policy issuance and renewal services increased 5.8% to
$437.8 million and 5.7% to $838.3 million in the second quarter and six months
ended June 30, 2021 , compared to the same periods in 2020, due to higher
commissions driven by direct and affiliated assumed written premium growth,
personnel costs and technology investments.
Management fee revenue for administrative services decreased 1.0% to $14.7
million and 0.2% to $29.5 million in the second quarter and six months ended
June 30, 2021 , compared to the same periods in 2020. The administrative services
reimbursement revenue and corresponding cost of operations increased both total
operating revenue and total operating expenses by $157.2 million in the second
quarter of 2021 and $310.7 million for the six months ended June 30, 2021 , but
had no net impact on operating income.
Total investment income increased $4.9 million and $32.0 million in the second
quarter and six months ended June 30, 2021 , compared to the same periods in
2020. The results from both periods were primarily due to increases in net
investment income. Investment results in 2020 were impacted by the significant
financial market volatility resulting from the COVID-19 pandemic.
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. As the COVID-19
pandemic continues to evolve, the extent and duration of the impacts to economic
conditions remain uncertain. See Financial Condition and Liquidity and Capital
Resources contained within this report, as well as Part I. Item 1A. "Risk
Factors" related to COVID-19 included in our Annual Report on Form 10-K for the
fiscal year ended December 31, 2020 as filed with the Securities and Exchange
Commission on February 25, 2021 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 was seen in the global financial markets at the onset of the COVID-19
pandemic and pandemic related events may create future volatility. 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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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 2021 and 2020. 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, includes variable consideration and 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 and the related allocation at least 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. Our current transaction
price allocation review resulted in a minor change in the allocation percentages
between the two performance obligations. The change in allocation will not have
a material impact on our financial statements.
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) 2021 2020 % Change 2021 2020 % Change
(Unaudited) (Unaudited)
Policy issuance and renewal services
Direct and affiliated assumed premiums written
by the Exchange $ 2,070,557 $ 2,002,753 3.4 % $ 3,948,739 $ 3,850,431 2.6 %
Management fee rate 24.3 % 24.2 % 24.3 % 24.2 %
Management fee revenue 503,146 484,666 3.8 959,544 931,804 3.0
Change in estimate for management fee returned
on cancelled policies (1) (875) (871) (0.4) (1,555) (4,259) 63.5
Management fee revenue - policy issuance and
renewal services $ 502,271 $ 483,795 3.8 % $ 957,989 $ 927,545 3.3 %
Administrative services
Direct and affiliated assumed premiums written
by the Exchange $ 2,070,557 $ 2,002,753 3.4 % $ 3,948,739 $ 3,850,431 2.6 %
Management fee rate 0.7 % 0.8 % 0.7 % 0.8 %
Management fee revenue 14,494 16,022 (9.5) 27,641 30,803 (10.3)
Change in contract liability (2) 168 (1,184) NM 1,875 (1,183) NM
Change in estimate for management fee returned on cancelled policies (1) 5 (25) NM (2) (36) 95.8 Management fee revenue - administrative services 14,667 14,813 (1.0) 29,514 29,584
(0.2)
Administrative services reimbursement revenue 157,190 151,965 3.4
310,723 303,519 2.4
Total revenue from administrative services$ 171,857 $ 166,778 3.0 %$ 340,237 $ 333,103 2.1 % NM = not meaningful (1)A constraining estimate of variable consideration exists related to the potential for management fees to be returned if a policy were to be cancelled mid-term. Management fees are returned to the Exchange when policies are cancelled mid-term and unearned premiums are refunded. (2)Management fee revenue - administrative services is recognized over time as the services are provided. See Part I, Item 1. "Financial Statements - Note 3, Revenue, of Notes to Financial Statements" contained within this report. 27 -------------------------------------------------------------------------------- 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 3.4% to$2.1 billion in the second quarter of 2021 compared to the second quarter of 2020, primarily driven by increases in homeowners and commercial multi-peril premiums written. Year-over-year policies in force for all lines of business increased 3.6% in the second quarter of 2021 compared to 1.1% in the second quarter of 2020. The year-over-year average premium per policy for all lines of business decreased 1.5% atJune 30, 2021 compared to an increase of 2.2% atJune 30, 2020 . The year-over-year average premium per policy atJune 30, 2021 was impacted by the rate reductions for our personal and commercial auto policies that became effective in the third quarter of 2020. Premiums generated from new business increased 38.4% to$263 million in the second quarter of 2021. While year-over-year average premium per policy on new business decreased 2.7% atJune 30, 2021 , new business policies written increased 33.4 % in the second quarter of 2021. Premiums generated from new business decreased 18.6% to$190 million in the second quarter of 2020. Year-over-year average premium per policy on new business decreased 0.4% atJune 30, 2020 and new business policies written decreased 12.7% in the second quarter of 2020, primarily due to the shelter-at-home orders and mandatory business closures resulting from the COVID-19 pandemic. Premiums generated from renewal business decreased 0.3% to$1.8 billion in the second quarter of 2021 compared to the second quarter of 2020. Underlying the trend in renewal business premiums was a decrease in year-over-year average premium per policy of 1.2% atJune 30, 2021 , driven by the rate reductions for our personal and commercial auto policies that became effective in the third quarter of 2020, compared to an increase of 2.5% atJune 30, 2020 . Personal lines - Total personal lines premiums written increased 2.0% to$1.5 billion in the second quarter of 2021, compared to 0.7% in the second quarter of 2020. While total personal lines year-over-year average premium per policy decreased 2.1% atJune 30, 2021 , total personal lines policies in force increased 3.6% in the second quarter of 2021. Commercial lines - Total commercial lines premiums written increased 6.8% to$619 million in the second quarter of 2021, compared to a decrease of 0.1% in the second quarter of 2020, driven by a 3.4% increase in total commercial lines policies in force and a 0.1% increase in total commercial lines year-over-year average premium per policy. Future trends-premium revenue - Through a careful agency selection process, the Exchange plans to continue its effort to expand the size of its agency force to increase market penetration in existing operating territories to contribute to future growth. Changes in premium levels attributable to the growth in policies in force and rate changes directly affect the profitability of the Exchange and have a direct bearing on our management fee. Future premiums could be impacted by changes resulting from the COVID-19 pandemic, including potential regulatory changes and inflationary trends, among others. Longer-term, increased driving activity may result in future rate increases due to higher claims frequencies and severity. See also Part I. Item 1A. "Risk Factors" related to COVID-19 included in our Annual Report on Form 10-K for the fiscal year endedDecember 31, 2020 as filed with theSecurities and Exchange Commission onFebruary 25, 2021 . 28 -------------------------------------------------------------------------------- Table of Contents Policy issuance and renewal services Three months ended June 30, Six months ended June 30, (dollars in thousands) 2021 2020 % Change 2021 2020 % Change (Unaudited) (Unaudited) Management fee revenue - policy issuance and renewal services$ 502,271 $ 483,795 3.8 %$ 957,989 $ 927,545 3.3 % Service agreement revenue 5,902 6,446 (8.4) 11,981 13,108 (8.6) 508,173 490,241 3.7 969,970 940,653 3.1
Cost of policy issuance and renewal services 437,775 413,865 5.8
838,324 793,357 5.7
Operating income - policy issuance and
renewal services $ 70,398 $ 76,376 (7.8) % $ 131,646 $ 147,296 (10.6) %
Policy issuance and renewal services
The management fee revenue allocated for providing policy issuance and renewal
services was 24.3% and 24.2% of the direct and affiliated assumed premiums
written by the Exchange for both the three and six months ended June 30, 2021
and 2020, respectively. 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 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) 2021 2020 % Change 2021 2020 % Change
(Unaudited) (Unaudited)
Commissions:
Total commissions $ 293,220 $ 278,478 5.3 % $ 554,601 $ 530,474 4.5 %
Non-commission expense:
Underwriting and policy processing $ 43,181 $ 39,891 8.2 % $ 83,769 $ 81,243 3.1 %
Information technology 46,076 43,155 6.8 92,481 85,313 8.4
Sales and advertising 14,590 15,770 (7.5) 25,533 27,245 (6.3)
Customer service 9,131 8,631 5.8 17,929 17,210 4.2
Administrative and other 31,577 27,940 13.0 64,011 51,872 23.4
Total non-commission expense 144,555 135,387 6.8 283,723 262,883 7.9
Total cost of policy issuance and renewal
services $ 437,775 $ 413,865 5.8 % $ 838,324 $ 793,357 5.7 %
Commissions - Commissions increased $14.7 million in the second quarter of 2021
and $24.1 million for the six months ended June 30, 2021 compared to the same
periods in 2020, primarily driven by the growth in direct and affiliated assumed
written premium, primarily in lines of business that pay a higher commission
rate. To a lesser extent, there was also an increase in agent incentive
compensation for the second quarter and six months ended June 30, 2021 compared
to the second quarter and six months ending June 30, 2020 . The estimated agent
incentive payouts at June 30, 2021 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 2021. Lower claims frequency and related loss
expense since the onset of the COVID-19 pandemic impacted agent compensation
related to the profitability component in all periods.
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Non-commission expense - Non-commission expense increased $9.2 million in the
second quarter of 2021 compared to the second quarter of 2020. Underwriting and
policy processing expense increased $3.3 million primarily due to increased
personnel costs and underwriting report costs. Information technology costs
increased $2.9 million primarily due to increased hardware and software costs as
well as increased personnel costs. Administrative and other costs increased $3.6
million primarily driven by increased building and equipment depreciation and
professional fees compared to the same period in 2020. Personnel costs in all
expense categories for the second quarter of 2021 were impacted by higher
medical costs compared to the prior year as the COVID-19 pandemic reduced
elective procedures in 2020.
Non-commission expense increased $20.8 million in the six months ended June 30,
2021 compared to the same period of 2020. Underwriting and policy processing
expense increased $2.5 million primarily due to increased underwriting report
costs and personnel costs. Information technology costs increased $7.2 million
primarily due to increased hardware and software costs and personnel costs.
Administrative and other costs increased $12.1 million primarily driven by
increased personnel costs and professional fees compared to the same period in
2020. Personnel costs in all expense categories were impacted by higher pension
costs and higher medical costs compared to the prior year as the COVID-19
pandemic reduced elective procedures in 2020.
Administrative services
Three months ended June 30, Six months ended June 30,
(dollars in thousands) 2021 2020 % Change 2021 2020 % Change
(Unaudited) (Unaudited)
Management fee revenue - administrative
services $ 14,667 $ 14,813 (1.0) % $ 29,514 $ 29,584 (0.2) %
Administrative services reimbursement
revenue 157,190 151,965 3.4 310,723 303,519 2.4
Total revenue allocated to administrative
services 171,857 166,778 3.0 340,237 333,103 2.1
Administrative services expenses
Claims handling services 135,192 131,474 2.8 267,662 263,777 1.5
Investment management services 9,689 8,353 16.0 19,403 17,410 11.5
Life management services 12,309 12,138 1.4 23,658 22,332 5.9
Operating income - administrative services $ 14,667 $ 14,813 (1.0) % $ 29,514 $ 29,584 (0.2) %
Administrative services
The management fee revenue allocated to administrative services was 0.7% and
0.8% of the direct and affiliated assumed premiums written by the Exchange for
both the three and six months ended June 30, 2021 and 2020, respectively. 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.
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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) 2021 2020 % Change 2021 2020 % Change
(Unaudited) (Unaudited)
Net investment income $ 13,650 $ 5,044 NM $ 30,747 $ 9,708 NM
Net realized investment gains (losses) 2,769 6,526 (57.6) % 3,573 (4,280) NM
Net impairment (losses) recoveries recognized in earnings (1) (17) NM 86 (3,070) NM Total investment income$ 16,418 $ 11,553 42.1 %$ 34,406 $ 2,358 NM NM = not meaningful Net investment income Net investment income includes interest and dividends on our fixed maturity and equity security portfolios and the results of our limited partnership investments, net of investment expenses. Net investment income increased$8.6 million in the second quarter of 2021 and$21.0 million for the six months endedJune 30, 2021 , compared to the same periods in 2020. The results from both periods were primarily due to equity in earnings of limited partnerships of$6.2 million and$15.2 million for the three and six months endedJune 30, 2021 , respectively, compared to equity in losses of limited partnerships of$2.3 million and$6.0 million , respectively, for the same periods in 2020. We have made no new limited partnership commitments since 2006, and the balance of limited partnership investments is expected to decline over time as additional distributions are received. 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) 2021 2020 2021 2020 Securities sold: (Unaudited) (Unaudited)
Available-for-sale securities $ 397$ 355 $ 1,880 $ 970 Equity securities 392 (1,840) 899 (2,528) Equity securities change in fair value 1,979 8,010 793 (2,724) Miscellaneous 1 1 1 2
Net realized investment gains (losses)
Net realized gains during the second quarter of 2021 were primarily driven by market value adjustments on equity securities while net realized gains for the six months endedJune 30, 2021 were primarily due to disposals of available-for-sale securities. Net realized gains during the second quarter of 2020 were primarily driven by increases in the fair value of equity securities while net realized losses for the six months endedJune 30, 2020 were driven by the significant financial market volatility resulting from the COVID-19 pandemic. Net impairment (losses) recoveries recognized in earnings Net impairment losses during the second quarter of 2021 and net impairment recoveries for the six months endedJune 30, 2021 were on credit impaired available-for-sale securities. Net impairment losses in 2020 were primarily due to the COVID-19 pandemic's impact on financial markets on our available-for-sale securities. 31
-------------------------------------------------------------------------------- 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 27, 2021 , 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 2.6% to$3.9 billion in the first six months of 2021 compared to the first six months of 2020. 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$11.7 billion atJune 30, 2021 ,$10.7 billion atDecember 31, 2020 , and$9.4 billion atJune 30, 2020 . 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, 2021 ,December 31, 2020 andJune 30, 2020 . 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 defined risk tolerances. However, see Part I. Item 1A. "Risk Factors" related to COVID-19 included in our Annual Report on Form 10-K for the fiscal year endedDecember 31, 2020 as filed with theSecurities and Exchange Commission onFebruary 25, 2021 for possible outcomes that could impact that determination. 32 -------------------------------------------------------------------------------- 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) June 30, 2021 % to total December 31, 2020 % to total
(Unaudited)
Fixed maturities $ 936,798 83 % $ 928,236 84 %
Equity securities:
Preferred stock 93,798 8 94,071 9
Common stock 207 0 19 0
Agent loans (1) 68,558 6 69,212 6
Other investments 28,845 3 14,325 1
Total investments $ 1,128,206 100 % $ 1,105,863 100 %
(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$17.2 million atJune 30, 2021 , compared to net unrealized gains of$23.3 million atDecember 31, 2020 . The following table presents a breakdown of the fair value of our fixed maturity portfolio by industry sector and rating as of: (in thousands) June 30, 2021 (1) Non- investment Fair AAA AA A BBB grade value (Unaudited) Basic materials$ 0 $ 0 $ 3,225 $ 2,125 $ 9,248 $ 14,598 Communications 0 8,792 8,511 17,656 17,837 52,796 Consumer 0 3,198 21,798 66,610 44,033 135,639 Diversified 0 0 0 1,045 624 1,669 Energy 0 4,176 7,881 19,251 11,952 43,260 Financial 0 1,019 64,308 115,182 15,604 196,113 Industrial 0 0 10,061 16,524 22,583 49,168 Structured securities (2) 165,284 132,377 35,852 17,204 0 350,717 Technology 5,230 0 7,864 22,275 12,438 47,807 U.S. Treasury 0 21,391 0 0 0 21,391 Utilities 0 0 3,843 16,307 3,490 23,640 Total$ 170,514 $ 170,953 $ 163,343 $ 294,179 $ 137,809 $ 936,798 (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. 33 -------------------------------------------------------------------------------- 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, 2021 December 31, 2020 Preferred stock Common stock Preferred stock Common stock (Unaudited) Communications $ 2,161 $ 0$ 2,699 $ 0 Consumer 2,295 0 3,068 0 Energy 2,745 207 2,187 19 Financial services 75,212 0 76,575 0 Industrial 915 0 800 0 Utilities 10,470 0 8,742 0 Total $ 93,798 $ 207$ 94,071 $ 19 34
-------------------------------------------------------------------------------- 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 2021. 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. 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 contained within this report and Part I. Item 1A. "Risk Factors" related to COVID-19 included in our Annual Report on Form 10-K for the fiscal year endedDecember 31, 2020 as filed with theSecurities and Exchange Commission onFebruary 25, 2021 . 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 2021 and beyond. Cash flow activities The following table provides condensed cash flow information for the six months endedJune 30 : (in thousands) 2021 2020 (Unaudited) (Unaudited)
Net cash provided by operating activities
(35,511) (115,423)
Net cash used in financing activities (97,411)
(90,860)
Net decrease in cash and cash equivalents
Net cash provided by operating activities was$127.7 million in the first six months of 2021, compared to$127.3 million in the first six months of 2020. Increased cash provided by operating activities in the six months of 2021 was primarily due to an increase in management fees received driven by growth in direct and affiliated assumed premiums written by the Exchange of$47.4 million and an increase in administrative service reimbursements received of$21.8 million . Partially offsetting the increase in cash provided by operating activities was an increase in cash paid for agent commissions and agent bonuses of$15.9 million and$15.5 million , respectively, due to higher scheduled commission driven by premium growth, and increases in income taxes and salaries and wages paid of$14.9 million and$13.1 million , respectively, in the first six months of 2021 compared to the same period in 2020. Net cash used in investing activities was$35.5 million in the first six months of 2021, compared to$115.4 million in the same period in 2020. In the first half of 2021, net cash used in investing activities was primarily driven by fixed asset purchases, as purchases of investments were offset by proceeds from sales and and maturities/calls of investments. Net cash used in investing activities in the first half of 2020 was primarily due to purchases of available-for-sale securities exceeding the proceeds generated from investment sales and maturities/calls of available-for-sale securities. Net cash used in financing activities totaled$97.4 million in the first half of 2021, compared to$90.9 million in the first half of 2020. The increase in cash used in the first half of 2021, compared to the same period in 2020, was due to dividends paid to shareholders. We increased both our Class A and Class B shareholder regular quarterly dividends by 7.3% for 2021, compared to 2020. There are no regulatory restrictions on the payment of dividends to our shareholders. 35 -------------------------------------------------------------------------------- Table of Contents There were no repurchases of our Class A nonvoting common stock in the first six months of 2021 and 2020 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, 2021 , based upon trade date. During the six months endedJune 30, 2021 , we purchased 23,558 shares of our outstanding Class A nonvoting common stock outside of our publicly announced share repurchase program at a total cost of$4.7 million . Of this amount, we purchased 978 shares for$0.2 million , or$242.01 per share, for stock-based awards in conjunction with our equity compensation plan. We purchased 2,603 shares for$0.6 million , or$227.05 per share, to fund the rabbi trust for the outside director deferred stock compensation plan. The remaining 19,977 shares were purchased at a total cost of$3.9 million , or$196.35 per share, to fund the rabbi trust for the incentive compensation deferral plan. All shares were delivered as ofJune 30, 2021 . 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 . 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$156.0 million atJune 30, 2021 , 2) a$100 million bank revolving line of credit, and 3) liquidation of unpledged assets held in our investment portfolio, including preferred stock and investment grade bonds, which totaled approximately$655.7 million atJune 30, 2021 . 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, 2021 , 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, 2021 , 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, 2021 . Investments with a fair value of$123.4 million were pledged as collateral on the line atJune 30, 2021 . 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, 2021 . 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, 2021 , there were no material changes to our future contractual obligations as previously reported in our Annual Report on Form 10-K for the fiscal year endedDecember 31, 2020 as filed with theSecurities and Exchange Commission onFebruary 25, 2021 . 36
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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, 2020 of our Annual Report on Form 10-K as filed with theSecurities and Exchange Commission onFebruary 25, 2021 . 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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