Allowance for Loan Losses and Credit Quality

The ALL is established for estimated losses in the loan portfolio through a provision for loan losses charged to earnings. For all loan classes, loan losses are charged against the ALL when management believes the loan balance is uncollectible or in accordance with federal guidelines. Subsequent recoveries, if any, are credited to the ALL.

The ALL is maintained at a level believed by management to be appropriate to absorb probable credit losses inherent in the loan portfolio as of the balance sheet date. The amount of the ALL is based on management's periodic evaluation of the collectability of the loan portfolio, including the nature, volume and risk characteristics of the portfolio, credit concentrations, trends in historical loss experience, estimated value of any underlying collateral, specific impaired loans and economic conditions. There has been no change to the methodology used to estimate the ALL during the third quarter of 2017. While management uses available information to recognize losses on loans, future additions to the ALL may be necessary based on changes in economic conditions or other relevant factors.

In addition, various regulatory agencies, as an integral part of their examination process, regularly review the Company's ALL. Such agencies may require the Company to recognize additions to the ALL, with a corresponding charge to earnings, based on their judgments about information available to them at the time of their examination, which may not be currently available to management.

The ALL consists of specific, general and unallocated components. The specific component relates to the loans that are classified as impaired. Loans are evaluated for impairment and may be classified as impaired when management believes it is probable that the Company will not collect all the contractual interest and principal payments as scheduled in the loan agreement. Impaired loans may also include troubled loans that are restructured. A TDR occurs when the Company, for economic or legal reasons related to the borrower's financial difficulties, grants a concession to the borrower that would otherwise not be granted. A TDR classification may result from the transfer of assets to the Company in partial satisfaction of a troubled loan, a modification of a loan's terms (such as reduction of stated interest rates below market rates, extension of maturity that does not conform to the Company's policies, reduction of the face amount of the loan, reduction of accrued interest, or reduction or deferment of loan payments), or a combination. A specific reserve amount is allocated to the ALL for individual loans that have been classified as impaired based on management's estimate of the fair value of the collateral for collateral dependent loans, an observable market price, or the present value of anticipated future cash flows. The Company accounts for the change in present value attributable to the passage of time in the loan loss reserve. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer, real estate or small balance commercial loans for impairment evaluation, unless such loans are subject to a restructuring agreement or have been identified as impaired as part of a larger customer relationship. Management has established the threshold for individual impairment evaluation for commercial loans with balances greater than $500 thousand, based on an evaluation of the Company's historical loss experience on substandard commercial loans.

The general component represents the level of ALL allocable to each loan portfolio segment with similar risk characteristics and is determined based on historical loss experience, adjusted for qualitative factors, for each class of loan. Management deems a five year average to be an appropriate time frame on which to base historical losses for each portfolio segment. Qualitative factors considered include underwriting, economic and market conditions, portfolio composition, collateral values, delinquencies, lender experience and legal issues. The qualitative factors are determined based on the various risk characteristics of each portfolio segment. Risk characteristics relevant to each portfolio segment are as follows:

•

Residential real estate - Loans in this segment are collateralized by owner-occupied 1-4 family residential real estate, second and vacation homes, 1-4 family investment properties, home equity and second mortgage loans. Repayment is dependent on the credit quality of the individual borrower. The overall health of the economy, including unemployment rates and housing prices, could have an effect on the credit quality of this segment.

•

Construction real estate - Loans in this segment include residential and commercial construction properties, commercial real estate development loans (while in the construction phase of the projects), land and land development loans. Repayment is dependent on the credit quality of the individual borrower and/or the underlying cash flows generated by the properties being constructed. The overall health of the economy, including unemployment rates, housing prices, vacancy rates and material costs, could have an effect on the credit quality of this segment.

•

Commercial real estate - Loans in this segment are primarily properties occupied by businesses or income-producing properties. The underlying cash flows generated by the properties may be adversely impacted by a downturn in the economy as evidenced by a general slowdown in business or increased vacancy rates which, in turn, could have an effect on the credit quality of this segment. Management requests business financial statements at least annually and monitors the cash flows of these loans.


•	Commercial - Loans in this segment are made to businesses and are generally secured by non-real estate assets of the business. Repayment is expected from the cash flows of the business. A weakened economy, and resultant decreased consumer or business spending, could have an effect on the credit quality of this segment.


•	Consumer - Loans in this segment are made to individuals for personal expenditures, such as an automobile purchase, and include unsecured loans. Repayment is primarily dependent on the credit quality of the individual borrower. The overall health of the economy, including unemployment, could have an effect on the credit quality of this segment.


•	Municipal - Loans in this segment are made to municipalities located within the Company's service area. Repayment is primarily dependent on taxes or other funds collected by the municipalities. Management considers there to be minimal risk surrounding the credit quality of this segment.

An unallocated component is maintained to cover uncertainties that could affect management's estimate of probable losses. The unallocated component of the ALL reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

All evaluations are inherently subjective as they require estimates that are susceptible to significant revision as more information becomes available or as changes occur in economic conditions or other relevant factors. Despite the allocation shown in the tables below, the ALL is general in nature and is available to absorb losses from any class of loan.

Changes in the ALL, by class of loans, for the three and nine months ended September 30, 2017 and 2016 were as follows:



For The Three Months Ended September 30, 2017	Residential Real Estate			Construction Real Estate			Commercial Real Estate		Commercial			Consumer			Municipal		Unallocated		Total
	(Dollars in thousands)
Balance, June 30, 2017	$	1,387		$	481		$	2,753	$	362		$	24		$	26	$	135	$	5,168
Provision (credit) for loan losses	56			(76		)	37		(6		)	3			39		97		150
Recoveries of amounts charged off	36			3			—		3			1			—		—		43
	1,479			408			2,790		359			28			65		232		5,361
Amounts charged off	(100		)	—			—		—			(2		)	—		—		(102		)
Balance, September 30, 2017	$	1,379		$	408		$	2,790	$	359		$	26		$	65	$	232	$	5,259



For The Three Months Ended September 30, 2016	Residential Real Estate		Construction Real Estate		Commercial Real Estate			Commercial		Consumer			Municipal		Unallocated			Total
	(Dollars in thousands)
Balance, June 30, 2016	$	1,382	$	373	$	2,837		$	240	$	27		$	26	$	341		$	5,226
Provision (credit) for loan losses	11		28		(64		)	5		4			20		(4		)	—
Recoveries of amounts charged off	—		3		—			1		—			—		—			4
	1,393		404		2,773			246		31			46		337			5,230
Amounts charged off	—		—		—			—		(4		)	—		—			(4		)
Balance, September 30, 2016	$	1,393	$	404	$	2,773		$	246	$	27		$	46	$	337		$	5,226



For The Nine Months Ended September 30, 2017	Residential Real Estate			Construction Real Estate		Commercial Real Estate		Commercial		Consumer			Municipal		Unallocated			Total
	(Dollars in thousands)
Balance, December 31, 2016	$	1,399		$	391	$	2,687	$	342	$	26		$	40	$	362		$	5,247
Provision (credit) for loan losses	124			8		103		13		7			25		(130		)	150
Recoveries of amounts charged off	38			9		—		4		2			—		—			53
	1,561			408		2,790		359		35			65		232			5,450
Amounts charged off	(182		)	—		—		—		(9		)	—		—			(191		)
Balance, September 30, 2017	$	1,379		$	408	$	2,790	$	359	$	26		$	65	$	232		$	5,259



For The Nine Months Ended September 30, 2016	Residential Real Estate			Construction Real Estate			Commercial Real Estate			Commercial			Consumer			Municipal		Unallocated		Total
	(Dollars in thousands)
Balance, December 31, 2015	$	1,419		$	514		$	2,792		$	209		$	28		$	38	$	201	$	5,201
Provision (credit) for loan losses	79			(119		)	(19		)	62			3			8		136		150
Recoveries of amounts charged off	15			9			—			8			3			—		—		35
	1,513			404			2,773			279			34			46		337		5,386
Amounts charged off	(120		)	—			—			(33		)	(7		)	—		—		(160		)
Balance, September 30, 2016	$	1,393		$	404		$	2,773		$	246		$	27		$	46	$	337	$	5,226

The allocation of the ALL, summarized on the basis of the Company's impairment methodology by class of loan, as of the balance sheet dates were as follows:



September 30, 2017	Residential Real Estate		Construction Real Estate		Commercial Real Estate		Commercial		Consumer		Municipal		Unallocated		Total
	(Dollars in thousands)
Individually evaluated for impairment	$	57	$	—	$	4	$	—	$	—	$	—	$	—	$	61
Collectively evaluated for impairment	1,322		408		2,786		359		26		65		232		5,198
Total allocated	$	1,379	$	408	$	2,790	$	359	$	26	$	65	$	232	$	5,259



December 31, 2016	Residential Real Estate		Construction Real Estate		Commercial Real Estate		Commercial		Consumer		Municipal		Unallocated		Total
	(Dollars in thousands)
Individually evaluated for impairment	$	63	$	—	$	40	$	—	$	—	$	—	$	—	$	103
Collectively evaluated for impairment	1,336		391		2,647		342		26		40		362		5,144
Total allocated	$	1,399	$	391	$	2,687	$	342	$	26	$	40	$	362	$	5,247

The recorded investment in loans, summarized on the basis of the Company's impairment methodology by class of loan, as of the balance sheet dates were as follows:



September 30, 2017	Residential Real Estate		Construction Real Estate		Commercial Real Estate		Commercial		Consumer		Municipal		Total
	(Dollars in thousands)
Individually evaluated for impairment	$	1,939	$	84	$	1,484	$	393	$	—	$	—	$	3,900
Collectively evaluated for impairment	174,460		36,712		255,708		47,773		3,832		56,517		575,002
Total	$	176,399	$	36,796	$	257,192	$	48,166	$	3,832	$	56,517	$	578,902



December 31, 2016	Residential Real Estate		Construction Real Estate		Commercial Real Estate		Commercial		Consumer		Municipal		Total
	(Dollars in thousands)
Individually evaluated for impairment	$	1,448	$	88	$	3,328	$	432	$	—	$	—	$	5,296
Collectively evaluated for impairment	171,279		34,101		245,735		41,567		3,962		31,350		527,994
Total	$	172,727	$	34,189	$	249,063	$	41,999	$	3,962	$	31,350	$	533,290

Risk and collateral ratings are assigned to loans and are subject to ongoing monitoring by lending and credit personnel with such ratings updated annually or more frequently if warranted. The following is an overview of the Company's loan rating system:

1-3 Rating - Pass

Risk-rating grades "1" through "3" comprise those loans ranging from those with lower than average credit risk, defined as borrowers with high liquidity, excellent financial condition, strong management, favorable industry trends or loans secured by highly liquid assets, through those with marginal credit risk, defined as borrowers that, while creditworthy, exhibit some characteristics requiring special attention by the account officer.

4/M Rating - Satisfactory/Monitor

Borrowers exhibit potential credit weaknesses or downward trends warranting management's attention. While potentially weak, these borrowers are currently marginally acceptable; no loss of principal or interest is envisioned. When warranted, these credits may be monitored on the watch list.

5-7 Rating - Substandard

Borrowers exhibit well defined weaknesses that jeopardize the orderly liquidation of debt. The loan may be inadequately protected by the net worth and paying capacity of the obligor and/or the underlying collateral is inadequate.

The following tables summarize the loan ratings applied to the Company's loans by class as of the balance sheet dates:



September 30, 2017	Residential Real Estate		Construction Real Estate		Commercial Real Estate		Commercial		Consumer		Municipal		Total
	(Dollars in thousands)
Pass	$	163,064	$	29,466	$	166,776	$	43,323	$	3,797	$	56,517	$	462,943
Satisfactory/Monitor	9,921		7,164		86,809		4,181		32		—		108,107
Substandard	3,414		166		3,607		662		3		—		7,852
Total	$	176,399	$	36,796	$	257,192	$	48,166	$	3,832	$	56,517	$	578,902



December 31, 2016	Residential Real Estate		Construction Real Estate		Commercial Real Estate		Commercial		Consumer		Municipal		Total
	(Dollars in thousands)
Pass	$	158,140	$	29,248	$	182,247	$	38,219	$	3,928	$	31,350	$	443,132
Satisfactory/Monitor	10,641		4,830		62,193		3,109		34		—		80,807
Substandard	3,946		111		4,623		671		—		—		9,351
Total	$	172,727	$	34,189	$	249,063	$	41,999	$	3,962	$	31,350	$	533,290

The following tables provide information with respect to impaired loans by class of loan as of and for the three and nine months ended September 30, 2017 and September 30, 2016:



	As of September 30, 2017						For The Three Months Ended September 30, 2017				For The Nine Months Ended September 30, 2017
	Recorded Investment (1)		Principal Balance (1)		Related Allowance		Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
	(Dollars in thousands)
Residential real estate	$	300	$	310	$	57
Commercial real estate	140		143		4
With an allowance recorded	440		453		61

Residential real estate	1,639		2,168		—
Construction real estate	84		84		—
Commercial real estate	1,344		1,417		—
Commercial	393		393		—
With no allowance recorded	3,460		4,062		—

Residential real estate	1,939		2,478		57		$	1,855	$	23	$	1,684	$	54
Construction real estate	84		84		—		84		1		86		3
Commercial real estate	1,484		1,560		4		1,626		18		2,200		72
Commercial	393		393		—		400		7		412		19
Total	$	3,900	$	4,515	$	61	$	3,965	$	49	$	4,382	$	148

____________________


(1)	Does not reflect government guaranties on impaired loans as of September 30, 2017 totaling $564 thousand.



	As of September 30, 2016						For The Three Months Ended September 30, 2016				For The Nine Months Ended September 30, 2016
	Recorded Investment (1)		Principal Balance (1)		Related Allowance		Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
	(Dollars in thousands)
Residential real estate	$	1,388	$	1,788	$	57	$	1,346	$	7	$	1,266	$	23
Construction real estate	89		89		—		89		1		91		3
Commercial real estate	2,883		2,981		61		3,018		28		3,059		59
Commercial	451		451		—		456		—		470		—
Total	$	4,811	$	5,309	$	118	$	4,909	$	36	$	4,886	$	85

____________________


(1)	Does not reflect government guaranties on impaired loans as of September 30, 2016 totaling $654 thousand.

The following table provides information with respect to impaired loans as of December 31, 2016:



	December 31, 2016
	Recorded Investment (1)		Principal Balance (1)		Related Allowance
	(Dollars in thousands)
Residential real estate	$	308	$	317	$	63
Commercial real estate	488		520		40
With an allowance recorded	796		837		103

Residential real estate	1,140		1,561		—
Construction real estate	88		88		—
Commercial real estate	2,840		2,910		—
Commercial	432		432		—
With no allowance recorded	4,500		4,991		—

Residential real estate	1,448		1,878		63
Construction real estate	88		88		—
Commercial real estate	3,328		3,430		40
Commercial	432		432		—
Total	$	5,296	$	5,828	$	103

____________________


(1)	Does not reflect government guaranties on impaired loans as of December 31, 2016 totaling $637 thousand.

The following is a summary of TDR loans by class of loan as of the balance sheet dates:



	September 30, 2017			December 31, 2016
	Number of Loans	Principal Balance		Number of Loans	Principal Balance
	(Dollars in thousands)
Residential real estate	28	$	1,939	20	$	1,448
Construction real estate	1	84		1	88
Commercial real estate	10	1,091		10	1,452
Commercial	2	393		2	431
Total	41	$	3,507	33	$	3,419

The TDR loans above represent loan modifications in which a concession was provided to the borrower, including due date extensions, maturity date extensions, interest rate reductions or the forgiveness of accrued interest. Troubled loans, that are restructured and meet established thresholds, are classified as impaired and a specific reserve amount is allocated to the ALL on the basis of the fair value of the collateral for collateral dependent loans, an observable market price, or the present value of anticipated future cash flows.

The following tables provide new TDR activity for the three and nine months ended September 30, 2017 and September 30, 2016:



	New TDRs During the					New TDRs During the
	Three Months Ended September 30, 2017					Nine Months Ended September 30, 2017
	Number of Loans	Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Number of Loans	Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
	(Dollars in thousands)
Residential real estate	3	$	269	$	276	9	$	649	$	673
Commercial real estate	1	149		149		2	293		293



	New TDRs During the					New TDRs During the
	Three Months Ended September 30, 2016					Nine Months Ended September 30, 2016
	Number of Loans	Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Number of Loans	Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
	(Dollars in thousands)
Residential real estate	3	$	89	$	99	6	$	278	$	295
Commercial real estate	4	643		647		6	803		807

There were no TDR loans modified within the previous twelve months that had subsequently defaulted during the three and nine month periods ended September 30, 2017 or September 30, 2016. TDR loans are considered defaulted at 90 days past due.

At September 30, 2017 and December 31, 2016, the Company was not committed to lend any additional funds to borrowers whose loans were nonperforming, impaired or restructured.