0000842517-19-000052.txt : 20190314 0000842517-19-000052.hdr.sgml : 20190314 20190314164519 ACCESSION NUMBER: 0000842517-19-000052 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 131 CONFORMED PERIOD OF REPORT: 20181231 FILED AS OF DATE: 20190314 DATE AS OF CHANGE: 20190314 FILER: COMPANY DATA: COMPANY CONFORMED NAME: ISABELLA BANK Corp CENTRAL INDEX KEY: 0000842517 STANDARD INDUSTRIAL CLASSIFICATION: STATE COMMERCIAL BANKS [6022] IRS NUMBER: 382830092 STATE OF INCORPORATION: MI FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 000-18415 FILM NUMBER: 19681637 BUSINESS ADDRESS: STREET 1: 401 NORTH MAIN STREET CITY: MT PLEASANT STATE: MI ZIP: 48858 BUSINESS PHONE: 9897729471 MAIL ADDRESS: STREET 1: 401 NORTH MAIN STREET CITY: MT PLEASANT STATE: MI ZIP: 48858 FORMER COMPANY: FORMER CONFORMED NAME: ISABELLA BANK CORP DATE OF NAME CHANGE: 20080602 FORMER COMPANY: FORMER CONFORMED NAME: IBT BANCORP INC /MI/ DATE OF NAME CHANGE: 19920703 10-K 1 isba_20181231x10k.htm 10-K Document

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2018
OR
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from              to             
Commission File Number: 0-18415
Isabella Bank Corporation
(Exact name of registrant as specified in its charter)
Michigan
 
38-2830092
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
identification No.)
401 North Main Street, Mount Pleasant, Michigan 48858
(Address of principal executive offices) (Zip Code)
Registrant’s telephone number, including area code (989) 772-9471
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
 
Name of each exchange on which registered
Securities registered pursuant to Section 12(g) of the Act:
Common Stock - No Par Value
(Title of Class)
Indicated by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    ¨  Yes    x  No
Indicated by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.     ¨  Yes    x  No
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     x  Yes    ¨  No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    x  Yes    ¨  No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.   ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See definition of “large accelerated filer”, “accelerated filer”, “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act (Check One).
Large accelerated filer
 
¨
 
Accelerated filer
 
x
 
 
 
 
 
Non-accelerated filer
 
¨
 
Smaller reporting company
 
¨
 
 
 
 
 
 
 
 
 
 
 
Emerging growth company
 
¨
 
 
 
 
 
 
 
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.
 
¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    ¨  Yes    x  No
The aggregate market value of the voting stock held by non-affiliates of the registrant was $211,421,000 as of the last business day of the registrant’s most recently completed second fiscal quarter.
The number of common shares outstanding of the registrant’s Common Stock (no par value) was 7,873,337 as of March 11, 2019.
 
DOCUMENTS INCORPORATED BY REFERENCE
(Such documents are incorporated herein only to the extent specifically set forth in response to an item herein.)
Portions of the Isabella Bank Corporation Proxy Statement for its Annual Meeting of Shareholders to be held May 7, 2019 are incorporated by reference in this Form 10-K in response to Part III. The Isabella Bank Corporation Proxy Statement will be mailed on or before March 25, 2019.

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ISABELLA BANK CORPORATION
ANNUAL REPORT ON FORM 10-K
Table of Contents
PART I
 
 
 
 
 
 
 
 
Item 1.
 
 
 
 
 
 
 
Item 1A.
 
 
 
 
 
 
 
Item 1B.
 
 
 
 
 
 
 
Item 2.
 
 
 
 
 
 
 
Item 3.
 
 
 
 
 
 
 
Item 4.
 
 
 
 
 
 
 
PART II
 
 
 
 
 
 
 
 
Item 5.
 
 
 
 
 
 
 
Item 6.
 
 
 
 
 
 
 
Item 7.
 
 
 
 
 
 
 
Item 7A.
 
 
 
 
 
 
 
Item 8.
 
 
 
 
 
 
 
Item 9.
 
 
 
 
 
 
 
Item 9A.
 
 
 
 
 
 
 
Item 9B.
 
 
 
 
 
 
 
PART III
 
 
 
 
 
 
 
 
Item 10.
 
 
 
 
 
 
 
Item 11.
 
 
 
 
 
 
 
Item 12.
 
 
 
 
 
 
 
Item 13.
 
 
 
 
 
 
 
Item 14.
 
 
 
 
 
 
 
PART IV
 
 
 
 
 
 
 
 
Item 15.
 
 
 
 
 
 
 
Item 16.
 
 
 
 
 
 
 
SIGNATURES
 
 
 

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Forward Looking Statements
This report contains certain forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Rule 175 promulgated thereunder, and Section 21E of the Securities Exchange Act of 1934, as amended and Rule 3b-6 promulgated thereunder. We intend such forward looking statements to be covered by the safe harbor provisions for forward looking statements contained in the Private Securities Litigation Reform Act of 1995, and are included in this statement for purposes of these safe harbor provisions. Forward looking statements, which are based on certain assumptions and describe future plans, strategies and expectations, are generally identifiable by use of the words “believe,” “expect,” “intend,” “anticipate,” “estimate,” “project,” or similar expressions. Our ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the operations and future prospects include, but are not limited to, changes in: interest rates, general economic conditions, federal or state tax laws, monetary and fiscal policy, the quality or composition of the loan or investment portfolio, demand for loan products, fluctuation in the value of collateral securing our loan portfolio, deposit flows, competition, cybersecurity risk, demand for financial services in our market area, and accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating forward looking statements and undue reliance should not be placed on such statements. Further information concerning our business, including additional factors that could materially affect our consolidated financial results, is included in our filings with the SEC.
Glossary of Acronyms and Abbreviations
The acronyms and abbreviations identified below may be used throughout this Annual Report on Form 10-K or in our other SEC filings. You may find it helpful to refer back to this page while reading this report.
ACL: Allowance for Credit Losses
 
GAAP: U.S. generally accepted accounting principles
AFS: Available-for-sale
 
GLB Act: Gramm-Leach-Bliley Act of 1999
ALLL: Allowance for loan and lease losses
 
IFRS: International Financial Reporting Standards
AOCI: Accumulated other comprehensive income
 
IRR: Interest rate risk
ASC: FASB Accounting Standards Codification
 
ISDA: International Swaps and Derivatives Association
ASU: FASB Accounting Standards Update
 
JOBS Act: Jumpstart our Business Startups Act
ATM: Automated Teller Machine
 
LIBOR: London Interbank Offered Rate
BHC Act: Bank Holding Company Act of 1956
 
N/A: Not applicable
CECL: Current Expected Credit Losses
 
N/M: Not meaningful
CFPB: Consumer Financial Protection Bureau
 
NASDAQ: NASDAQ Stock Market Index
CIK: Central Index Key
 
NASDAQ Banks: NASDAQ Bank Stock Index
CRA: Community Reinvestment Act
 
NAV: Net asset value
DIF: Deposit Insurance Fund
 
NOW: Negotiable order of withdrawal
DIFS: Department of Insurance and Financial Services
 
NSF: Non-sufficient funds
Directors Plan: Isabella Bank Corporation and Related Companies Deferred Compensation Plan for Directors
 
OCI: Other comprehensive income (loss)
Dividend Reinvestment Plan: Isabella Bank Corporation Stockholder Dividend Reinvestment Plan and Employee Stock Purchase Plan
 
OMSR: Originated mortgage servicing rights
Dodd-Frank Act: Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010
 
OREO: Other real estate owned
ESOP: Employee Stock Ownership Plan
 
OTTI: Other-than-temporary impairment
Exchange Act: Securities Exchange Act of 1934
 
PBO: Projected benefit obligation
FASB: Financial Accounting Standards Board
 
PCAOB: Public Company Accounting Oversight Board
FDI Act: Federal Deposit Insurance Act
 
Rabbi Trust: A trust established to fund our Directors Plan
FDIC: Federal Deposit Insurance Corporation
 
SEC: U.S. Securities and Exchange Commission
FFIEC: Federal Financial Institutions Examinations Council
 
SOX: Sarbanes-Oxley Act of 2002
FRB: Federal Reserve Bank
 
Tax Act: Tax Cuts and Jobs Act, enacted December 22, 2017
FHLB: Federal Home Loan Bank
 
TDR: Troubled debt restructuring
Freddie Mac: Federal Home Loan Mortgage Corporation
 
XBRL: eXtensible Business Reporting Language
FTE: Fully taxable equivalent
 
Yield Curve: U.S. Treasury Yield Curve

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PART I
Item 1. Business. (Dollars in thousands)
General
Isabella Bank Corporation is a registered financial services holding company that was incorporated in September 1988 under Michigan law. The Corporation's wholly owned subsidiary, Isabella Bank, has 30 banking offices located throughout Clare, Gratiot, Isabella, Mecosta, Midland, Montcalm, and Saginaw counties. The area includes significant agricultural production, manufacturing, retail, gaming and tourism, and several colleges and universities.
As used in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations as well as in Item 8. Financial Statements and Supplementary Data, references to “the Corporation”, “Isabella”, “we”, “our”, “us”, and similar terms refer to the consolidated entity consisting of Isabella Bank Corporation and its subsidiary. References to Isabella Bank or the “Bank” refers to Isabella Bank Corporation’s subsidiary, Isabella Bank.
Our reportable segments are based on legal entities that account for at least 10% of net operating results. Retail banking operations for 2018, 2017, and 2016 represent approximately 90% or greater of total assets and operating results. As such, we have only one reportable segment.
We are a community bank with a focus on providing high quality, personalized service at a fair price. We offer a broad array of banking services to businesses, institutions, individuals and their families. We compete with other commercial banks, savings and loan associations, mortgage brokers, finance companies, credit unions, retail brokerage firms, and other companies providing financial services.
Lending activities include loans for commercial and agricultural operating and real estate purposes, residential real estate loans, and consumer loans. We limit lending activities primarily to local markets and have not purchased any loans from the secondary market. We do not make loans to fund leveraged buyouts, have no foreign corporate or government loans, and have limited holdings of corporate debt securities. Our general lending philosophy is to limit concentrations to individuals and business segments. For additional information related to our lending strategies and policies, see “Note 4 – Loans and ALLL” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data.
Deposit services offered include checking accounts, savings accounts, certificates of deposit, direct deposits, cash management services, mobile and internet banking, electronic bill pay services, and automated teller machines. We also offer full service investment management and trust services.
As of December 31, 2018, we had 371 full-time equivalent employees. We provide group life, health, accident, disability, and other insurance programs as well as a number of other employee benefit programs. None of our workforce is subject to collective bargaining agreements.
Available Information
Our SEC filings (including our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Definitive Proxy Statements, Current Reports on Form 8-K and amendments to those reports) are available through our website (www.isabellabank.com). We will provide paper copies of our SEC reports free of charge upon request by a shareholder.
The SEC maintains a website (www.sec.gov) that contains reports, proxy and information statements and other information regarding Isabella Bank Corporation (CIK #0000842517) and other issuers.
Supervision and Regulation
The earnings and growth of the banking industry are affected by the credit policies of monetary authorities, including the FRB. An important function of the FRB is to regulate the national supply of bank credit in order to combat recessions and respond to inflationary pressures. Among the instruments of monetary policy used by the FRB to implement these objectives are open market operations in U.S. Treasury and U.S. Government Agency securities, changes in the discount rate on member bank borrowings, and changes in reserve requirements against member bank deposits. These methods are used in varying combinations to influence overall growth of bank loans, investments and deposits and also affect interest rates charged on loans or paid for deposits. The monetary policies of the FRB have had a significant effect on the operating results of commercial banks and related financial service providers in the past and are expected to continue to do so in the future. The effect of such policies upon our future business and earnings cannot be predicted.
We, as a financial holding company, are regulated under the BHC Act, and are subject to the supervision of the FRB. We are registered as a financial services holding company with the FRB and are subject to reporting requirements and inspections and

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audits. Under FRB policy, we are expected to act as a source of financial strength to the Bank and to commit resources to support its subsidiaries. This support may be required at times when, in the absence of such FRB policy, it would not otherwise be required to provide support.
Under Michigan law, if the capital of a Michigan state chartered bank has become impaired by losses or otherwise, the Commissioner of the DIFS may require that the deficiency in capital be met by assessment upon the bank’s shareholders. Each shareholder would be responsible for a pro rata share of the deficiency, based on the amount of capital stock held by each shareholder. If an assessment is not paid by any shareholder within 30 days of the date of notice to the shareholder, sale of their stock will occur in order to pay such assessment.
Any capital loans by a bank holding company to any of its subsidiary banks are subordinate in right of payment to deposits and to certain other indebtedness of such subsidiary bank. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to a priority of payment. This priority would apply to guarantees of capital plans under the FDIC Improvement Act of 1991.
SOX contains important requirements for public companies in the area of financial disclosure and corporate governance. In accordance with Section 302(a) of SOX, written certifications by our principal executive, financial, and accounting officers are required. These certifications attest that our quarterly and annual reports filed with the SEC do not contain any untrue statement of a material fact (see the certifications filed as Exhibits 31 (a) and (b) to this Form 10-K for such certification of consolidated financial statements and other information for this 2018 Form 10-K). We have also implemented a program designed to comply with Section 404 of SOX, which included the identification of significant processes and accounts, documentation of the design effectiveness over process and entity level controls, and testing of the operating effectiveness of key controls. See Item 9A. Controls and Procedures for our evaluation of disclosure controls and procedures and internal control over financial reporting.
Certain additional information concerning regulatory guidelines for capital adequacy and other regulatory matters is presented herein under the caption “Capital” in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations and in “Note 9 – Off-Balance-Sheet Activities, Commitments and Other Matters” and “Note 10 – Minimum Regulatory Capital Requirements” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data.
Isabella Bank
The Bank is supervised and regulated by DIFS and the FRB. These agencies and federal and state laws extensively regulate various aspects of the banking business including, among other things, permissible types and amounts of loans, investments and other activities, capital adequacy, branching, interest rates on loans and deposits, and the safety and soundness of banking practices.
Our deposits are insured up to applicable limits by the DIF of the FDIC and are subject to deposit insurance assessments to maintain the DIF. The FDIC assesses insurance premiums based upon a financial ratios method that takes into account asset and capital levels and supervisory ratings.
Banking laws and regulations restrict transactions by insured banks owned by a bank holding company. These restrictions include loans to and certain purchases from the parent holding company, non-bank and bank subsidiaries of the parent holding company. Additional restrictions apply to principal shareholders, officers, directors and their affiliates, and investments by the subsidiary bank in the shares or securities of the parent holding company (or any of the other non-bank or bank affiliates), or acceptance of such shares or securities as collateral security for loans to any borrower.
The Bank is subject to legal limitations on the frequency and amount of dividends that can be paid to Isabella Bank Corporation. For example, a Michigan state chartered bank may not declare a cash dividend or a dividend in kind except out of net profits then on hand after deducting all losses and bad debts, and then only if it will have a surplus amounting to not less than 20% of its capital after the payment of the dividend. Moreover, a Michigan state chartered bank may not declare or pay any cash dividend or dividend in kind until the cumulative dividends on its preferred stock, if any, have been paid in full. Further, if the surplus of a Michigan state chartered bank is at any time less than the amount of its capital, before the declaration of a cash dividend or dividend in kind, it must transfer to surplus not less than 10% of its net profits for the preceding six months (in the case of quarterly or semi-annual dividends) or the preceding two consecutive six month periods (in the case of annual dividends).
The payment of dividends by Isabella Bank Corporation and the Bank is also affected by various regulatory requirements and policies, such as the requirement to keep adequate capital in compliance with regulatory guidelines. Federal laws impose

5


further restrictions on the payment of dividends by insured banks that fail to meet specified capital levels. The FDIC may prevent an insured bank from paying dividends if the bank is in default of payment of any assessment due to the FDIC. In addition, payment of dividends by a bank may be prevented by the applicable federal regulatory authority if such payment is determined, by reason of the financial condition of such bank, to be an unsafe and unsound banking practice. The FRB and the FDIC have issued policy statements providing that bank holding companies and insured banks should generally pay dividends only out of current operating earnings. Additionally, the FRB Board of Governors requires a bank holding company to notify the FRB prior to increasing its cash dividend by more than 10% over the prior year.
The aforementioned regulations and restrictions may limit our ability to obtain funds from the Bank for our cash needs, including payment of dividends and operating expenses.
The activities and operations of the Bank are also subject to various federal and state laws and regulations.
Item 1A. Risk Factors.
In the normal course of business, we are exposed to various risks. These risks, if not managed correctly, could have a significant impact on our earnings, capital, share price, and ability to pay dividends. In order to effectively monitor and control the following risks, we utilize an enterprise risk model. We balance our strategic goals, including revenue and profitability objectives, with associated risks through the use of policies, systems, and procedures which have been adopted to identify, assess, control, monitor, and manage each risk area. We continually review the adequacy and effectiveness of these policies, systems, and procedures.
Our enterprise risk process covers each of the following areas.
Changes in credit quality and required allowance for loan and lease losses
To manage the credit risk arising from lending activities, our most significant source of credit risk, we maintain sound underwriting policies and procedures. We continuously monitor asset quality in order to manage our credit risk to determine the appropriateness of valuation allowances. These valuation allowances take into consideration various factors including, but not limited to, local, regional, and national economic conditions.
We maintain an ALLL to reserve for estimated incurred loan losses within our loan portfolio. The level of the ALLL reflects our evaluation of industry concentrations; specific credit risks; loan loss experience; loan portfolio quality; and economic, political and regulatory conditions. The determination of the appropriate level of the ALLL inherently involves a high degree of subjectivity and requires us to make significant estimates, all of which may undergo material changes.
Changes in economic conditions
An economic downturn within our local markets, as well as downturns in the state, national, or global markets, could negatively impact household and corporate incomes. This could lead to decreased demand for both loan and deposit products and lead to an increase of customers who fail to pay interest or principal on their loans. We continually monitor key economic indicators in an effort to anticipate the possible effects of downturns in the local, regional, and national economies.
Our success depends primarily on the general economic conditions of the State of Michigan and the specific local markets in which we operate. Unlike banks that are more geographically diversified, we provide banking and financial services to customers located primarily in the Clare, Gratiot, Isabella, Mecosta, Midland, Montcalm, and Saginaw counties in Michigan. The local economic conditions in these areas have a significant impact on the demand for our products and services, as well as the ability of our customers to repay loans, the value of the collateral securing loans, and the stability of our deposit funding sources. A significant decline in general economic conditions, caused by inflation, recession, acts of terrorism, outbreak of hostilities or other international or domestic occurrences, unemployment, changes in securities markets or other factors could impact these local economic conditions and, in turn, have a material adverse effect on our financial condition and results of operations.
Interest rate risk
IRR results from the timing differences in the maturity or repricing frequency of a financial institution’s interest earning assets and its interest bearing liabilities. We monitor the potential effects of changes in interest rates through simulations and gap analyses. To help mitigate the effects of changes in interest rates, we make significant efforts to stagger projected cash flows and maturities of interest sensitive assets and liabilities.

6


Liquidity risk
Liquidity risk is the risk to earnings or capital arising from our inability to meet our obligations when they come due without incurring unacceptable costs. Liquidity risk includes the inability to manage unplanned changes in funding sources, or failure to address changes in market conditions that affect the ability to liquidate assets quickly and with minimal loss in value. We have significant borrowing capacity through correspondent banks and the ability to sell certain investments to fund potential cash shortages, which we may use to help mitigate this risk.
The value of investment securities may be negatively impacted by fluctuations in the market
A volatile, illiquid market or decline in credit quality could require us to recognize an OTTI loss related to the investment securities held in our portfolio. We consider many factors in determining whether an OTTI exists including the length of time and extent to which fair value has been less than cost, the investment credit rating, and the probability that the issuer will be unable to pay the amount when due. The presence of these factors could lead to impairment charges. These risks are mitigated by the fact that we do not intend to sell the security in an unrealized loss position and it is more likely than not that we will not have to sell the security before recovery of its cost basis.
Operational risk
Operational risk is the risk of loss resulting from inadequate or failed internal processes, people, and systems, or external events and includes reputation risk and transaction risk. Reputation risk is managed by developing and retaining marketplace confidence in handling customers’ financial transactions in an appropriate manner and protecting our safety and soundness. Transaction risk includes losses from fraud, error, the inability to deliver products or services, and loss or theft of information. Transaction risk also encompasses product development and delivery, transaction processing, information technology systems, and the internal control environment.
To minimize potential losses due to operational risks, we have established a robust system of internal controls that is regularly tested by our internal audit department in conjunction with the services of certified public accounting firms who assist in performing such internal audit work. The focus of these internal audit procedures is to verify the validity and appropriateness of various transactions, processes, and controls. The results of these procedures are reported to our Audit Committee.
The adoption of, violations of, or nonconformance with laws, rules, regulations, or prescribed practices
The financial services industry and public companies are extensively regulated and must meet regulatory standards set by the FDIC, DIFS, FRB, FASB, SEC, PCAOB, CFPB, and other regulatory bodies. Federal and state laws and regulations are designed primarily to protect deposit insurance funds and consumers, and not necessarily to benefit our shareholders. The nature, extent, and timing of the adoption of significant new laws, changes in existing laws, or repeal of existing laws may have a material impact on our business, results of operations, and financial condition, the effect of which is impossible to predict at this time.
Our compliance department annually assesses the adequacy and effectiveness of our processes for controlling and managing our principal compliance risks.
Changes to the financial services industry as a result of regulatory changes or actions, or significant litigation
The financial services industry is extensively regulated by state and federal regulation that governs almost all aspects of our operations. Laws and regulations may change from time-to-time and are primarily intended for the protection of consumers, depositors, and the deposit insurance fund. The impact of any changes to laws and regulations or other actions by regulatory agencies may negatively impact us or our ability to increase the value of our business. Regulatory authorities have extensive discretion in connection with their supervisory and enforcement activities, including the imposition of restrictions on the operation of an institution, the classification of assets by the institution, and the appropriateness of an institution’s ALLL. Future regulatory changes or accounting pronouncements may increase our regulatory capital requirements or adversely affect our regulatory capital levels. Additionally, actions by regulatory agencies or significant litigation against us could require the dedication of significant time and resources to defend our business and may lead to penalties.
We may not adjust to changes in the financial services industry
Our financial performance depends in part on our ability to maintain and grow our core deposit customer base and expand our financial services to our existing and new customers. The increasingly competitive environment is, in part, a result of changes in technology and product delivery systems and the accelerating pace of consolidation among financial service providers. New competitors may emerge to increase the degree of competition for our products and services. Financial services and products are also constantly changing. Our financial performance is dependent upon customer demand for our products and services,

7


our ability to develop and offer competitive financial products and services, and our ability to adapt to enhancements in financial technology.
We may be required to recognize an impairment of goodwill
Goodwill represents the excess of the amounts paid to acquire subsidiaries over the fair value of their net assets at the date of acquisition. The majority of the recorded goodwill is related to acquisitions of other banks, which were subsequently merged into Isabella Bank. If it is determined that the goodwill is impaired, we must write-down the goodwill by the amount of the impairment.
We may face pressure from purchasers of our residential mortgage loans to repurchase loans sold or reimburse purchasers for losses related to such loans
We generally sell the fixed rate long-term residential mortgage loans we originate to the secondary market. The purchasers of residential mortgage loans, such as government sponsored entities, increased their efforts to require sellers of residential mortgage loans to either repurchase loans previously sold, or reimburse the purchasers for losses incurred on foreclosed loans due to actual or alleged failure to strictly conform to the terms of the contract.
Consumers may decide not to use banks to complete their financial transactions
Technology and other changes are allowing customers to complete financial transactions without the involvement of banks. For example, consumers can now pay bills and transfer funds directly without banks. The process of eliminating banks as intermediaries in financial transactions could result in the loss of fee income, as well as the loss of customer deposits and income generated from those deposits.
Unauthorized disclosure of sensitive or confidential client or customer information, whether through cyber attacks, breach of computer systems or other means
Our products, services and systems are accessed through critical company or third-party operations. This involves the storage, processing and transmission of sensitive data, including proprietary or confidential data, regulated data, and personal information of employees and customers. Successful breaches, employee wrongdoing, or human or technological error could result in unauthorized access to, disclosure, modification, misuse, loss, or destruction of company, customer, or other third party data or systems. Examples include theft of sensitive, regulated, or confidential data including personal information; loss of access to critical data or systems through ransomware, destructive attacks or other means; and business delays, service or system disruptions or denials of service.
Cybersecurity incidents have increased in number and severity and it is expected that these trends will continue. Should we, or third parties we do business with, fall victim to successful cyber attacks or experience other cybersecurity incidents, including the loss of personally identifiable customer or other sensitive data, the result could severely damage our reputation, expose us to the risks of litigation and liability, disrupt our operations and increase cybersecurity or other insurance premiums.
We have cybersecurity insurance, in the event a cybersecurity attack were to occur, covering expenses related to notification, credit monitoring, investigation, crisis management, public relations, and legal advice. In addition, we maintain insurance to cover restoration of data, certain physical damage or third-party injuries caused by potential cybersecurity incidents. However, damage and claims arising from such incidents may not be covered or may exceed the amount of any insurance available. Insurance policies are reviewed annually in detail.
A strong reputation is vital and requires utmost protection. An operating incident, significant cybersecurity disruption, or other adverse event may have a negative impact on our reputation which could make it more difficult for us to compete successfully for new opportunities, obtain necessary regulatory approvals, or severely reduce consumer demand for our products.
Our estimates and assumptions may be incorrect
Our consolidated financial statements conform with GAAP, which require us to make estimates and assumptions that affect the amounts reported in the consolidated financial statements. Estimates are based on information available to us at the time the estimates are made. Actual results could differ from estimates. For further discussion regarding significant accounting estimates, see “Note 1 – Nature of Operations and Summary of Significant Accounting Policies” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data.

8


Disruption of infrastructure
Our operations depend upon our technological and physical infrastructure, including our equipment and facilities. Extended disruption of our vital infrastructure by fire, power loss, natural disaster, telecommunications failure, computer hacking and viruses, or other events outside of our control, could have a significant impact on our operations. We have developed and tested disaster recovery plans for all significant aspects of our operations.
Anti-takeover provisions
Our articles of incorporation include anti-takeover provisions that require a two-thirds majority vote to approve a sale of the Corporation. Additionally, changes to our articles of incorporation must be approved by a two-thirds majority vote of our shareholders. These provisions may make our stock less attractive to potential shareholders.
Item 1B. Unresolved Staff Comments.
None.
Item 2. Properties.
Our executive offices are located at 401 North Main Street in Mount Pleasant, Michigan. In addition to this location, we own 29 branches, two operations centers, our previous main office building and vacant land. We also lease property in Saginaw, Michigan which serves as a full-service branch. Our facilities' current, planned, and best use is for conducting our current activities, with the exception of our previous main office location which is vacant. We continually monitor and assess the need for expansion and/or improvement of all facilities. In our opinion, each facility has sufficient capacity and is in good condition.
Item 3. Legal Proceedings.
We are not involved in any material legal proceedings. We are involved in ordinary, routine litigation incidental to our business; however, no such routine proceedings are expected to result in any material adverse effect on our consolidated operations, earnings, financial condition, or cash flows.
Item 4. Mine Safety Disclosures.
Not applicable.

9


PART II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Common Stock and Dividend Information
Our authorized common stock consists of 15,000,000 shares, of which 7,870,969 shares are issued and outstanding as of December 31, 2018. As of that date, there were 3,083 shareholders of record.
Our common stock is traded in the over-the-counter market.  Our common stock is quoted on the OTCQX market tier of the OTC Markets Group Inc.’s ("OTC Markets") electronic quotation system (www.otcmarkets.com) under the symbol “ISBA”.  Other trades in our common stock occur in privately negotiated transactions from time to time of which we may have little or no information.
We have reviewed the information available as to the range of reported high and low bid quotations, including high and low bid information as reported by OTC Markets. The following table sets forth our compilation of that information for the periods indicated. Price information obtained from OTC Markets reflects inter-dealer prices, without retail mark up, mark down, or commissions and may not necessarily represent actual transactions. The following compiled data is provided for information purposes only and should not be viewed as indicative of the actual or market value of our common stock.

Number of
Common Shares
 
Sale Price
 
Low
 
High
2018
 
 
 
 
 
First Quarter
65,782

 
$
26.11

 
$
28.25

Second Quarter
78,922

 
26.25

 
27.25

Third Quarter
86,032

 
26.05

 
27.65

Fourth Quarter
73,364

 
22.50

 
27.00

 
304,100

 
 
 
 
2017
 
 
 
 
 
First Quarter
96,592

 
$
27.60

 
$
29.00

Second Quarter
64,160

 
27.60

 
28.45

Third Quarter
66,000

 
27.65

 
29.10

Fourth Quarter
60,227

 
27.99

 
29.95

 
286,979

 
 
 
 
The following table sets forth the cash dividends paid for the following quarters:

Per Share
 
2018
 
2017
First Quarter
$
0.26

 
$
0.25

Second Quarter
0.26

 
0.25

Third Quarter
0.26

 
0.26

Fourth Quarter
0.26

 
0.26

Total
$
1.04

 
$
1.02

We have adopted and publicly announced a common stock repurchase plan. The plan was last amended on August 22, 2018, to allow for the repurchase of an additional 200,000 shares of common stock after that date. These authorizations do not have expiration dates. As shares are repurchased under this plan, they are retired and revert back to the status of authorized, but unissued, shares.

10


The following table provides information for the unaudited three month period ended December 31, 2018, with respect to our common stock repurchase plan:

Common Shares Repurchased
 
Total Number of Common Shares Purchased as Part of Publicly Announced Plan or Program
 
Maximum Number of Common Shares That May Yet Be Purchased Under the Plans or Programs
 
Number
 
Average Price
Per Common Share
 
 
Balance, September 30
 
 
 
 
 
 
200,244

October 1 - 31
2,797

 
$
26.81

 
2,797

 
197,447

November 1 - 30
3,325

 
25.26

 
3,325

 
194,122

December 1 - 31
26,468

 
24.07

 
26,468

 
167,654

Balance, December 31
32,590

 
$
24.42

 
32,590

 
167,654

Information concerning securities authorized for issuance under equity compensation plans appears under Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
Stock Performance
The following graph compares the cumulative total shareholder return on our common stock for the last five years with the cumulative total return on (1) NASDAQ, which is comprised of all United States common shares traded on the NASDAQ and (2) the NASDAQ Banks, which is comprised of bank and bank holding company common shares traded on the NASDAQ over the same period. The graph assumes the value of an investment in the Corporation's common stock and each index was $100 at December 31, 2013 and all dividends were reinvested.
 a2018nasdaqgrapha02.jpg
Year
 
ISBA
 
NASDAQ
 
NASDAQ
Banks
12/31/2013
 
$
100.00

 
$
100.00

 
$
100.00

12/31/2014
 
98.00

 
114.83

 
104.92

12/31/2015
 
135.30

 
122.99

 
114.20

12/31/2016
 
130.50

 
134.02

 
157.56

12/31/2017
 
137.20

 
173.86

 
166.15

12/31/2018
 
114.10

 
168.98

 
139.28


11


Item 6. Selected Financial Data.
Results of Operations (Dollars in thousands except per share amounts)
The following table outlines the results of operations and provides certain key performance measures as of, and for the years ended, December 31:

2018
 
2017
 
2016
 
2015
 
2014
INCOME STATEMENT DATA
 
 
 
 
 
 
 
 
 
Interest income
$
63,864

 
$
58,413

 
$
53,666

 
$
51,502

 
$
51,148

Interest expense
15,631

 
12,494

 
10,865

 
10,163

 
9,970

Net interest income
48,233

 
45,919

 
42,801

 
41,339

 
41,178

Provision for loan losses
978

 
253

 
(135
)
 
(2,771
)
 
(668
)
Noninterest income
10,946

 
10,812

 
11,108

 
10,359

 
9,325

Noninterest expenses
42,817

 
40,225

 
37,897

 
36,051

 
35,103

Federal income tax expense (1)
1,363

 
3,016

 
2,348

 
3,288

 
2,344

Net income
$
14,021

 
$
13,237

 
$
13,799

 
$
15,130

 
$
13,724

PER SHARE
 
 
 
 
 
 
 
 
 
Basic earnings
$
1.78

 
$
1.69

 
$
1.77

 
$
1.95

 
$
1.77

Diluted earnings
$
1.74

 
$
1.65

 
$
1.73

 
$
1.90

 
$
1.74

Dividends
$
1.04

 
$
1.02

 
$
0.98

 
$
0.94

 
$
0.89

Tangible book value (2)
$
18.68

 
$
18.63

 
$
17.80

 
$
17.33

 
$
16.52

Quoted market value
 
 
 
 
 
 
 
 
 
High
$
28.25

 
$
29.95

 
$
29.90

 
$
29.90

 
$
24.00

Low
$
22.50

 
$
27.60

 
$
27.25

 
$
22.00

 
$
21.73

Close (3)
$
22.56

 
$
28.25

 
$
27.85

 
$
29.90

 
$
22.50

Common shares outstanding (3)
7,870,969

 
7,857,293

 
7,821,069

 
7,799,867

 
7,776,274

PERFORMANCE RATIOS
 
 
 
 
 
 
 
 
 
Return on average total assets
0.77
%
 
0.75
%
 
0.82
%
 
0.95
%
 
0.90
%
Return on average shareholders' equity
7.26
%
 
6.75
%
 
7.12
%
 
8.33
%
 
8.06
%
Return on average tangible shareholders' equity
9.14
%
 
9.09
%
 
9.95
%
 
11.46
%
 
10.80
%
Net interest margin yield (FTE) (1)
2.97
%
 
3.03
%
 
3.00
%
 
3.10
%
 
3.24
%
BALANCE SHEET DATA (3)
 
 
 
 
 
 
 
 
 
Gross loans
$
1,128,707

 
$
1,091,519

 
$
1,010,615

 
$
850,492

 
$
836,550

AFS securities
$
494,834

 
$
548,730

 
$
554,671

 
$
656,837

 
$
561,394

Total assets
$
1,837,307

 
$
1,813,130

 
$
1,732,151

 
$
1,668,112

 
$
1,549,543

Deposits
$
1,292,693

 
$
1,265,258

 
$
1,195,040

 
$
1,164,563

 
$
1,074,484

Borrowed funds
$
340,299

 
$
344,878

 
$
337,694

 
$
309,732

 
$
289,709

Shareholders' equity
$
195,519

 
$
194,905

 
$
187,899

 
$
183,971

 
$
174,594

Gross loans to deposits
87.31
%
 
86.27
%
 
84.57
%
 
73.03
%
 
77.86
%
ASSETS UNDER MANAGEMENT (3)
 
 
 
 
 
 
 
 
 
Loans sold with servicing retained
$
259,481

 
$
266,789

 
$
272,882

 
$
287,029

 
$
288,639

Assets managed by our Investment and Trust Services Department
$
447,487

 
$
478,146

 
$
427,693

 
$
405,109

 
$
383,878

Total assets under management
$
2,544,275

 
$
2,558,065

 
$
2,432,726

 
$
2,360,250

 
$
2,222,060

ASSET QUALITY (3)
 
 
 
 
 
 
 
 
 
Nonperforming loans to gross loans
0.65
%
 
0.31
%
 
0.17
%
 
0.09
%
 
0.50
%
Nonperforming assets to total assets
0.42
%
 
0.20
%
 
0.11
%
 
0.07
%
 
0.33
%
ALLL to gross loans
0.74
%
 
0.71
%
 
0.73
%
 
0.87
%
 
1.21
%
CAPITAL RATIOS (3)
 
 
 
 
 
 
 
 
 
Shareholders' equity to assets
10.64
%
 
10.75
%
 
10.85
%
 
11.03
%
 
11.27
%
Tier 1 leverage
8.72
%
 
8.54
%
 
8.56
%
 
8.52
%
 
8.59
%
Common equity tier 1 capital
12.58
%
 
12.23
%
 
12.39
%
 
13.44
%
 
N/A

Tier 1 risk-based capital
12.58
%
 
12.23
%
 
12.39
%
 
13.44
%
 
14.08
%
Total risk-based capital
13.26
%
 
12.86
%
 
13.04
%
 
14.17
%
 
15.19
%
(1) Calculations are based on a federal income tax rate of 21% in 2018 and 34% for all prior periods.
(2) Tangible book value calculations include unrealized gain/loss on AFS securities.
(3) At end of year

12


The following table outlines our interim results of operations and key performance measures as of, and for the unaudited periods ended:

Quarter to Date
 
December 31
2018
 
September 30
2018
 
June 30
2018
 
March 31
2018
 
December 31
2017
 
September 30
2017
 
June 30
2017
 
March 31
2017
Total interest income
$
16,611

 
$
16,419

 
$
15,713

 
$
15,121

 
$
15,078

 
$
14,976

 
$
14,498

 
$
13,861

Total interest expense
4,258

 
4,231

 
3,741

 
3,401

 
3,435

 
3,200

 
3,028

 
2,831

Net interest income
12,353

 
12,188

 
11,972

 
11,720

 
11,643

 
11,776

 
11,470

 
11,030

Provision for loan losses
342

 
(76
)
 
328

 
384

 
168

 
49

 
9

 
27

Noninterest income
2,860

 
2,863

 
2,736

 
2,487

 
2,710

 
2,698

 
2,788

 
2,616

Noninterest expenses
10,865

 
11,072

 
10,784

 
10,096

 
10,628

 
10,139

 
9,507

 
9,951

Federal income tax expense
476

 
359

 
263

 
265

 
836

 
750

 
898

 
532

Net income
$
3,530

 
$
3,696

 
$
3,333

 
$
3,462

 
$
2,721

 
$
3,536

 
$
3,844

 
$
3,136

PER SHARE
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Basic earnings
$
0.45

 
$
0.47

 
$
0.42

 
$
0.44

 
$
0.35

 
$
0.45

 
$
0.49

 
$
0.40

Diluted earnings
0.44

 
0.46

 
0.41

 
0.43

 
0.34

 
0.44

 
0.48

 
0.39

Dividends
0.26

 
0.26

 
0.26

 
0.26

 
0.26

 
0.26

 
0.25

 
0.25

Quoted market value (1)
22.56

 
26.75

 
26.65

 
27.40

 
28.25

 
29.00

 
28.00

 
27.60

Tangible book value (2)
18.68

 
19.44

 
19.36

 
19.16

 
18.96

 
18.82

 
18.62

 
18.34

(1) At end of period
(2) Tangible book value calculations include unrealized gain/loss on AFS securities.

13


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.
ISABELLA BANK CORPORATION FINANCIAL REVIEW
(Dollars in thousands except per share amounts)
The following is management’s discussion and analysis of the financial condition and results of our operations. This discussion and analysis is intended to provide a better understanding of the consolidated financial statements and statistical data included elsewhere in this Annual Report on Form 10-K.
Executive Summary
We reported net income of $14,021 and earnings per common share of $1.78 for the year ended December 31, 2018. Net income and earnings per common share for the year ended December 31, 2017 were $13,237 and $1.69, respectively. Interest income for the year ended December 31, 2018 increased $5,451 when compared to 2017 primarily as the result of strong loan growth, which totaled $37,188 during 2018. Net interest income increased by $2,314 for the year ended December 31, 2018 in comparison to 2017. The provision for loan losses increased by $725 and was the result of loan growth, increased charge-offs, and an increase in criticized assets largely related to our agricultural loan portfolio. Noninterest expenses for the year ended December 31, 2018 exceeded noninterest expenses in 2017 due to increased compensation and benefits, certain loan expenses and increased costs related to upgrades with technology and network security. Additionally in 2017, noninterest expenses were reduced by a settlement with an insurance claims administrator in favor of Isabella Bank. Net income in 2018 has benefited from the lower federal statutory tax rate established by the Tax Act.
As of December 31, 2018, total assets and assets under management were $1,837,307 and $2,544,275, respectively. Assets under management include loans sold and serviced of $259,481 and assets managed by our Investment and Trust Services Department of $447,487, in addition to assets on our consolidated balance sheet. In 2018, the loan growth of $37,188 was attributable to commercial portfolio growth of $24,770 and increases in residential real estate and consumer loans of $13,526, offset by a $1,108 decline in the agricultural portfolio. Loan growth was funded through maturities and the receipt of principal payments in the AFS securities portfolio and growth in total deposits. All regulatory capital ratios for the Bank exceeded the minimum thresholds to be considered a "well capitalized" institution.
Our net yield on interest earning assets (FTE) was 2.97% for 2018 and experienced a slight decline in comparison to prior periods. The FRB increased short-term interest rates during each quarter of 2018. Over the next few years, we anticipate incremental improvement in our net yield on interest earning assets as a result of a combination of our asset mix shifting to an increasing percentage of loans compared to investment securities, strategic growth in loans, and market driven loan pricing. We are committed to increasing earnings and shareholder value through growth in our loan portfolio, growth in our investment and trust services, increasing our presence within our geographic footprint, and managing operating costs.
The current interest rate environment, which consists of low rates and a flat yield curve, is having an impact on investor confidence in the financial sector. Interest rate environments with flattened yield curves generally result in a decline in the market price of bank stocks. In early 2017, the difference between the yields of the 2-year treasury and 10-year treasury notes was above 120 basis points. Since the first part of December 2018, the same yield variance has remained below 20 basis points, which is not favorable for financial institutions.
Bank stocks, in general, were negatively impacted in 2018 by the interest rate environment. The Nasdaq Bank Stock Index declined 19% in the fourth quarter of 2018. The price per share of our common stock fell approximately 16% from $26.75 on September 28, 2018 to $22.56 on December 31, 2018. Even within this declining period, there were a few trades that we were aware of at $25.95 per share between December 14, 2018 and December 24, 2018. Historically, our stock price lags market changes, both upward and downward, 60 to 90 days.
Our Board of Directors and management team closely monitor our stock price, and are focused on improving the metrics which should serve to have a favorable impact on the stock price. In the second half of 2018, we engaged the services of an investor relations firm whose mission is to help build brand awareness of Isabella Bank Corporation in the investment community, and get management in front of selected investment professionals and advisors through small group presentations. The feedback from this strategy has been positive thus far.
Recent Legislation
The Dodd-Frank Act of 2010, has already had, and is expected to continue to have, a negative impact on our operating results. The Dodd-Frank Act established the CFPB which has made significant changes in the regulation of financial institutions aimed at strengthening the oversight of the federal government over the operation of the financial services sector and increasing the

14


protection of consumers. Recent regulations issued by the CFPB regarding consumer lending, including residential mortgage lending, have increased our compensation expenses and this trend is expected to continue.
On July 2, 2013, the FRB published revised BASEL III Capital standards for banks. The rules redefine what is included or deducted from equity capital, changes risk weighting for certain on and off-balance sheet assets, increases the minimum required equity capital to be considered well capitalized, and introduces a capital cushion buffer. The rules, which are being gradually phased in between 2015 and 2019, are not expected to have a material impact on the Corporation but will require us to hold more capital than we have historically.
On December 22, 2017, the Tax Cuts and Jobs Act was enacted. The law established a flat corporate federal statutory income tax rate of 21%, effective January 1, 2018, and eliminated the corporate alternative minimum tax which can be carried forward and used to reduce future income tax. The tax law provided for a wide array of changes, only some of which had a direct impact on our federal income tax expense. Some of these changes included, but are not limited to, the following items: limits to the deduction for net interest expense; immediate expense (for tax purposes) for certain qualified depreciable assets; elimination or reduction of certain deductions related to meals and entertainment expenses; and limits to the deductibility of deposit insurance premiums.
Reclassifications
Certain amounts reported in management's discussion and analysis of financial condition and results of operations for 2017 and 2016 have been reclassified to conform with the 2018 presentation.
Other
We have not received any notices of regulatory actions as of March 12, 2019.
CRITICAL ACCOUNTING POLICIES
Our significant accounting policies are set forth in “Note 1 – Nature of Operations and Summary of Significant Accounting Policies” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data. Of these significant accounting policies, we consider our policies regarding the ALLL, acquisition intangibles and goodwill, and the determination of the fair value and assessment of OTTI of investment securities to be our most critical accounting policies.
The ALLL requires our most subjective and complex judgment. Changes in economic conditions and other external factors can have a significant impact on the ALLL and, therefore, the provision for loan losses and results of operations. We have developed policies and procedures for assessing the appropriateness of the ALLL, recognizing that this process requires a number of assumptions and estimates with respect to our loan portfolio. Our assessments may be impacted in future periods by changes in economic conditions, and the discovery of information with respect to borrowers which is not known to us at the time of the issuance of the consolidated financial statements. For additional discussion concerning our ALLL and related matters, see “Allowance for Loan and Lease Losses” and “Note 4 – Loans and ALLL” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data.
U.S. generally accepted accounting principles require that we determine the fair value of the assets and liabilities of an acquired entity, and record the fair value on the date of acquisition. We employ a variety of measures in the determination of the fair value, including the use of discounted cash flow analysis, market appraisals, and projected future revenue streams. For certain items that we believe we have the appropriate expertise to determine the fair value, we may choose to use our own calculations of the value. In other cases, where the value is not easily determined, we consult with independent experts to determine the fair value of the identified asset or liability. Once valuations have been adjusted, the net difference between the price paid for the acquired entity and the net value of assets acquired on our balance sheet, including identifiable intangibles, is recorded as goodwill. Acquisition intangibles and goodwill are qualitatively evaluated to determine if it is more likely than not that the carrying balance is impaired on at least an annual basis.
AFS securities are carried at fair value with changes in the fair value included as a component of other comprehensive income. Declines in the fair value of AFS securities below their cost that are other-than-temporary are reflected as realized losses in the consolidated statements of income. We evaluate AFS securities for indications of losses that are considered other-than-temporary, if any, on a regular basis. The market values for most AFS investment securities are typically obtained from outside sources and applied to individual securities within the portfolio. Municipal securities for which no readily determinable market values are available are priced using fair value curves which most closely match the securities' characteristics.

15


Average Balances, Interest Rates, and Net Interest Income
The following schedules present the daily average amount outstanding for each major category of interest earning assets, non-earning assets, interest bearing liabilities, and noninterest bearing liabilities for the last three years. These schedules also present an analysis of interest income and interest expense for the periods indicated. All interest income is reported on a FTE basis using a federal income tax rate of 21% in 2018 and 34% in 2017 and 2016. Loans in nonaccrual status, for the purpose of the following computations, are included in the average loan balances. FRB and FHLB restricted equity holdings are included in accrued income and other assets.

Year Ended December 31
 
2018
 
2017
 
2016
 
Average
Balance
 
Tax
Equivalent
Interest
 
Average
Yield /
Rate
 
Average
Balance
 
Tax
Equivalent
Interest
 
Average
Yield /
Rate
 
Average
Balance
 
Tax
Equivalent
Interest
 
Average
Yield /
Rate
INTEREST EARNING ASSETS
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans
$
1,120,021

 
$
49,229

 
4.40
%
 
$
1,040,630

 
$
43,537

 
4.18
%
 
$
922,333

 
$
38,537

 
4.18
%
Taxable investment securities (1)
341,095

 
8,294

 
2.43
%
 
361,783

 
8,564

 
2.37
%
 
392,810

 
8,746

 
2.23
%
Nontaxable investment securities
191,281

 
7,115

 
3.72
%
 
202,375

 
9,126

 
4.51
%
 
205,450

 
9,351

 
4.55
%
Fed funds sold
4

 

 
%
 
663

 
5

 
0.75
%
 

 

 
%
Other
35,719

 
1,062

 
2.97
%
 
26,815

 
737

 
2.75
%
 
25,557

 
668

 
2.61
%
Total earning assets
1,688,120

 
65,700

 
3.89
%
 
1,632,266

 
61,969

 
3.80
%
 
1,546,150

 
57,302

 
3.71
%
NONEARNING ASSETS
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance for loan losses
(8,094
)
 
 
 
 
 
(7,607
)
 
 
 
 
 
(7,638
)
 
 
 
 
Cash and demand deposits due from banks
19,770

 
 
 
 
 
19,309

 
 
 
 
 
18,178

 
 
 
 
Premises and equipment
28,349

 
 
 
 
 
28,933

 
 
 
 
 
28,670

 
 
 
 
Accrued income and other assets
87,895

 
 
 
 
 
99,456

 
 
 
 
 
101,995

 
 
 
 
Total assets
$
1,816,040

 
 
 
 
 
$
1,772,357

 
 
 
 
 
$
1,687,355

 
 
 
 
INTEREST BEARING LIABILITIES
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest bearing demand deposits
$
229,411

 
$
267

 
0.12
%
 
$
213,648

 
$
232

 
0.11
%
 
$
203,198

 
$
163

 
0.08
%
Savings deposits
361,743

 
1,698

 
0.47
%
 
356,963

 
1,091

 
0.31
%
 
336,859

 
663

 
0.20
%
Time deposits
454,916

 
7,296

 
1.60
%
 
433,562

 
5,486

 
1.27
%
 
429,731

 
5,010

 
1.17
%
Borrowed funds
344,352

 
6,370

 
1.85
%
 
352,400

 
5,685

 
1.61
%
 
319,049

 
5,029

 
1.58
%
Total interest bearing liabilities
1,390,422

 
15,631

 
1.12
%
 
1,356,573

 
12,494

 
0.92
%
 
1,288,837

 
10,865

 
0.84
%
NONINTEREST BEARING LIABILITIES
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Demand deposits
224,777

 
 
 
 
 
208,988

 
 
 
 
 
194,892

 
 
 
 
Other
7,597

 
 
 
 
 
10,641

 
 
 
 
 
9,841

 
 
 
 
Shareholders’ equity
193,244

 
 
 
 
 
196,155

 
 
 
 
 
193,785

 
 
 
 
Total liabilities and shareholders’ equity
$
1,816,040

 
 
 
 
 
$
1,772,357

 
 
 
 
 
$
1,687,355

 
 
 
 
Net interest income (FTE)
 
 
$
50,069

 
 
 
 
 
$
49,475

 
 
 
 
 
$
46,437

 
 
Net yield on interest earning assets (FTE)
 
 
 
 
2.97
%
 
 
 
 
 
3.03
%
 
 
 
 
 
3.00
%
(1) Includes taxable AFS securities and equity securities
Net interest income is the amount by which interest income on earning assets exceeds the interest expense on interest bearing liabilities. Net interest income is influenced by changes in the balance and mix of assets and liabilities and market interest rates. We exert some control over these factors; however, FRB monetary policy and competition have a significant impact. For

16


analytical purposes, net interest income is adjusted to an FTE basis by includng the income tax savings from interest on tax exempt loans, and nontaxable investment securities, thus making year to year comparisons more meaningful. The FTE adjustment is based on a federal income tax rate of 21% for 2018 and 34% for 2017 and 2016.
Volume and Rate Variance Analysis
The following table sets forth the effect of volume and rate changes on interest income and expense for the periods indicated. For the purpose of this table, changes in interest due to volume and rate were determined as follows:
Volume—change in volume multiplied by the previous period's FTE rate.
Rate—change in the FTE rate multiplied by the previous period's volume.
All interest income presented in the table below is reported on a FTE basis using a federal income tax rate of 21% for 2018 and 34% for 2017 and 2016. The change in interest due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.
 
2018 Compared to 2017 
 Increase (Decrease) Due to
 
2017 Compared to 2016 
 Increase (Decrease) Due to

Volume
 
Rate
 
Net
 
Volume
 
Rate
 
Net
Changes in interest income
 
 
 
 
 
 
 
 
 
 
 
Loans
$
3,423

 
$
2,269

 
$
5,692

 
$
4,949

 
$
51

 
$
5,000

Taxable investment securities
(499
)
 
229

 
(270
)
 
(715
)
 
533

 
(182
)
Nontaxable investment securities
(479
)
 
(1,532
)
 
(2,011
)
 
(139
)
 
(86
)
 
(225
)
Fed Funds Sold

 
(5
)
 
(5
)
 
5

 

 
5

Other
261

 
64

 
325

 
34

 
35

 
69

Total changes in interest income
2,706

 
1,025

 
3,731

 
4,134

 
533

 
4,667

Changes in interest expense
 
 
 
 
 
 
 
 
 
 
 
Interest bearing demand deposits
18

 
17

 
35

 
9

 
60

 
69

Savings deposits
15

 
592

 
607

 
42

 
386

 
428

Time deposits
281

 
1,529

 
1,810

 
45

 
431

 
476

Borrowed funds
(132
)
 
817

 
685

 
536

 
120

 
656

Total changes in interest expense
182

 
2,955

 
3,137

 
632

 
997

 
1,629

Net change in interest margin (FTE)
$
2,524

 
$
(1,930
)
 
$
594

 
$
3,502

 
$
(464
)
 
$
3,038

Our net yield on interest earning assets remained unchanged during most of 2018, improving slightly in the fourth quarter. The continuing flattening of the yield curve and rising deposit rates combined with a high concentration of AFS securities as a percentage of earning assets has also placed pressure on net interest margin.
 
Average Yield / Rate for the Three Month Periods Ended:

December 31
2018
 
September 30
2018
 
June 30
2018
 
March 31
2018
 
December 31
2017
Total earning assets
4.01
%
 
3.94
%
 
3.84
%
 
3.77
%
 
3.86
%
Total interest bearing liabilities
1.23
%
 
1.20
%
 
1.08
%
 
0.99
%
 
1.01
%
Net yield on interest earning assets (FTE)
3.01
%
 
2.95
%
 
2.95
%
 
2.95
%
 
3.02
%
 
Quarter to Date Net Interest Income (FTE)

December 31
2018
 
September 30
2018
 
June 30
2018
 
March 31
2018
 
December 31
2017
Total interest income (FTE)
$
17,005

 
$
16,873

 
$
16,191

 
$
15,631

 
$
15,939

Total interest expense
4,258

 
4,231

 
3,741

 
3,401

 
3,435

Net interest income (FTE)
$
12,747

 
$
12,642

 
$
12,450

 
$
12,230

 
$
12,504


17


Allowance for Loan and Lease Losses
The viability of any financial institution is ultimately determined by its management of credit risk. Loans represent our single largest concentration of risk. The ALLL is our estimation of incurred losses within the existing loan portfolio. We allocate the ALLL throughout the loan portfolio based on our assessment of the underlying risks associated with each loan segment. Our assessments include allocations based on specific impairment valuation allowances, historical charge-offs, internally assigned credit risk ratings, and past due and nonaccrual balances. A portion of the ALLL is not allocated to any one loan segment, but is instead a representation of other qualitative risks that reflect the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.
The following table summarizes our charge-offs, recoveries, provision for loan losses, and ALLL balances as of, and for the unaudited three month periods ended:

December 31
2018
 
September 30
2018
 
June 30
2018
 
March 31
2018
 
December 31
2017
Total charge-offs
$
253

 
$
179

 
$
566

 
$
103

 
$
401

Total recoveries
186

 
155

 
238

 
219

 
233

Net loan charge-offs (recoveries)
67

 
24

 
328

 
(116
)
 
168

Net loan charge-offs (recoveries) to average loans outstanding
0.01
%
 
 %
 
0.03
%
 
(0.01
)%
 
0.02
%
Provision for loan losses
$
342

 
$
(76
)
 
$
328

 
$
384

 
$
168

Provision for loan losses to average loans outstanding
0.03
%
 
(0.01
)%
 
0.03
%
 
0.04
 %
 
0.02
%
ALLL
$
8,375

 
$
8,100

 
$
8,200

 
$
8,200

 
$
7,700

ALLL as a % of loans at end of period
0.74
%
 
0.71
 %
 
0.71
%
 
0.75
 %
 
0.71
%
The following table summarizes our charge-off and recovery activity for the years ended December 31:

2018
 
2017
 
2016
 
2015
 
2014
ALLL at beginning of period
$
7,700

 
$
7,400

 
$
7,400

 
$
10,100

 
$
11,500

Charge-offs
 
 
 
 
 
 
 
 
 
Commercial and agricultural
626

 
265

 
57

 
134

 
590

Residential real estate
151

 
200

 
574

 
397

 
722

Consumer
324

 
306

 
285

 
373

 
316

Total charge-offs
1,101

 
771

 
916

 
904

 
1,628

Recoveries
 
 
 
 
 
 
 
 
 
Commercial and agricultural
328

 
453

 
540

 
549

 
550

Residential real estate
261

 
206

 
287

 
220

 
197

Consumer
209

 
159

 
224

 
206

 
149

Total recoveries
798

 
818

 
1,051

 
975

 
896

Provision for loan losses
978

 
253

 
(135
)
 
(2,771
)
 
(668
)
ALLL at end of period
$
8,375

 
$
7,700

 
$
7,400

 
$
7,400

 
$
10,100

Net loan charge-offs (recoveries)
$
303

 
$
(47
)
 
$
(135
)
 
$
(71
)
 
$
732

Net loan charge-offs (recoveries) to average loans outstanding
0.03
%
 
%
 
(0.01
)%
 
(0.01
)%
 
0.09
%
ALLL as a% of loans at end of period
0.74
%
 
0.71
%
 
0.73
 %
 
0.87
 %
 
1.21
%

18


We experienced a higher level of charge-offs in 2018 when compared to 2017 which was significantly related to one borrower and is therefore, not indicative of a trend in charge-off activity. While we have experienced a slight deterioration in credit quality indicators in recent periods, credit quality remains strong. Overall, our level of required reserve is modest due to strong credit quality, low historical loss factors, and a low amount of net charge-offs. The following table illustrates our changes within the two main components of the ALLL as of:

December 31
2018
 
September 30
2018
 
June 30
2018
 
March 31
2018
 
December 31
2017
ALLL
 
 
 
 
 
 
 
 
 
Individually evaluated for impairment
$
1,938

 
$
2,074

 
$
2,059

 
$
2,503

 
$
2,130

Collectively evaluated for impairment
6,437

 
6,026

 
6,141

 
5,697

 
5,570

Total
$
8,375

 
$
8,100

 
$
8,200

 
$
8,200

 
$
7,700

ALLL to gross loans
 
 
 
 
 
 
 
 
 
Individually evaluated for impairment
0.17
%
 
0.18
%
 
0.18
%
 
0.23
%
 
0.20
%
Collectively evaluated for impairment
0.57
%
 
0.53
%
 
0.53
%
 
0.52
%
 
0.51
%
Total
0.74
%
 
0.71
%
 
0.71
%
 
0.75
%
 
0.71
%
For further discussion of the allocation of the ALLL, see “Note 4 – Loans and ALLL” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data.
Loans Past Due and Loans in Nonaccrual Status
Fluctuations in past due and nonaccrual status loans can have a significant impact on the ALLL. To determine the potential impact and corresponding estimated losses, we analyze our historical loss trends on loans past due greater than 30 days and nonaccrual status loans. We monitor all loans that are past due and loans in nonaccrual status for indications of additional deterioration.

Total Past Due and Nonaccrual Loans as of December 31
 
2018
 
2017
 
2016
 
2015
 
2014
Commercial
$
2,722

 
$
2,518

 
$
3,347

 
$
1,015

 
$
4,496

Agricultural
5,377

 
2,367

 
1,251

 
1,232

 
309

Residential real estate
3,208

 
4,881

 
2,716

 
2,520

 
4,181

Consumer
105

 
70

 
115

 
31

 
138

Total
$
11,412

 
$
9,836

 
$
7,429

 
$
4,798

 
$
9,124

Total past due and nonaccrual loans to gross loans
1.01
%
 
0.90
%
 
0.74
%
 
0.56
%
 
1.09
%
Past due and nonaccrual status loans have increased over the last year but continue to be at low levels as a result of strong repayment performance. A summary of loans past due and in nonaccrual status, including the composition of the ending balance of nonaccrual status loans by type, is included in “Note 4 – Loans and ALLL” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data.
Troubled Debt Restructurings
We have taken a proactive approach to avoid foreclosures on borrowers who are willing to work with us in modifying their loans, thus making them more affordable. This approach has allowed certain borrowers to develop a payment structure that will allow them to continue making payments in lieu of foreclosure. The modifications have been successful for us and our customers as very few of the modified loans have resulted in foreclosures. At the time of the TDR, the loan is reviewed to determine whether or not to classify the loan as accrual or nonaccrual status. The majority of new modifications result in terms that satisfy our criteria for continued interest accrual. TDRs that have been placed in nonaccrual status may be placed back on accrual status after six months of continued performance and achievement of current payment status.
We restructure debt with borrowers who due to financial difficulties are unable to service their debt under the original terms. We may extend the amortization period, reduce interest rates, allow interest only payment structures, forgive principal, forgive interest, or grant a combination of these modifications. Typically, the modifications are for a period of three years or less. There were no TDRs that were government sponsored as of December 31, 2018 or December 31, 2017.

19


Losses associated with TDRs, if any, are included in the estimation of the ALLL during the quarter in which a loan is identified as a TDR, and we review the analysis of the ALLL estimation each reporting period thereafter to ensure its continued appropriateness.
The following table provides a roll-forward of TDRs for the years ended December 31, 2017 and 2018:

Accruing Interest
 
Nonaccrual
 
Total
 
Number
of
Loans
 
Balance
 
Number
of
Loans
 
Balance
 
Number
of
Loans
 
Balance
January 1, 2017
153

 
$
20,593

 
5

 
$
789

 
158

 
$
21,382

New modifications
20

 
7,128

 
8

 
1,138

 
28

 
8,266

Principal advances (payments)

 
(1,501
)
 

 
(127
)
 

 
(1,628
)
Loans paid off
(22
)
 
(1,500
)
 

 

 
(22
)
 
(1,500
)
Partial charge-offs

 

 

 
(170
)
 

 
(170
)
Balances charged-off
(2
)
 
(62
)
 

 

 
(2
)
 
(62
)
Transfers to OREO

 

 
(2
)
 
(91
)
 
(2
)
 
(91
)
Transfers to accrual status
2

 
126

 
(2
)
 
(126
)
 

 

Transfers to nonaccrual status
(4
)
 
(1,500
)
 
4

 
1,500

 

 

December 31, 2017
147

 
23,284

 
13

 
2,913

 
160

 
26,197

New modifications
27

 
6,623

 
18

 
1,733

 
45

 
8,356

Principal advances (payments)

 
(1,456
)
 

 
(714
)
 

 
(2,170
)
Loans paid off
(35
)
 
(4,361
)
 
(7
)
 
(819
)
 
(42
)
 
(5,180
)
Partial charge-offs

 

 

 
(39
)
 

 
(39
)
Balances charged-off

 

 
(1
)
 
(7
)
 
(1
)
 
(7
)
Transfers to OREO

 

 
(1
)
 
(206
)
 
(1
)
 
(206
)
Transfers to accrual status
1

 
520

 
(1
)
 
(520
)
 

 

Transfers to nonaccrual status
(7
)
 
(1,210
)
 
7

 
1,210

 

 

December 31, 2018
133

 
$
23,400

 
28

 
$
3,551

 
161

 
$
26,951

The following table summarizes our TDRs as of December 31:

2018
 
2017
 
2016

Accruing
Interest
 
Nonaccrual
 
Total
 
Accruing
Interest
 
Nonaccrual
 
Total
 
Accruing
Interest
 
Nonaccrual
 
Total
Current
$
21,794

 
$
2,673

 
$
24,467

 
$
21,234

 
$

 
$
21,234

 
$
17,557

 
$
559

 
$
18,116

Past due 30-59 days
899

 

 
899

 
1,778

 
805

 
2,583