10-Q 1 erie10-q03312018.htm 10-Q Document

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended March 31, 2018
 
Commission file number 0-24000
 
 
ERIE INDEMNITY COMPANY
 
 
(Exact name of registrant as specified in its charter)
 
 
PENNSYLVANIA
 
25-0466020
 
 
(State or other jurisdiction of
 
(I.R.S. Employer
 
 
incorporation or organization)
 
Identification No.)
 
 
 
100 Erie Insurance Place, Erie, Pennsylvania
 
16530
 
 
(Address of principal executive offices)
 
(Zip Code)
 
 
 
 
 
 
 
(814) 870-2000
 
 
(Registrant’s telephone number, including area code)
 
 
Not applicable
 
 
(Former name, former address and former fiscal year, if changed since last report)
 
  
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.
Yes [X]   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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes [X]   No [  ]
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company.  See the definitions 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 [X]            Accelerated filer [  ]        Non-accelerated filer [  ]
                                    (Do not check if a smaller reporting company)
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 [  ]   No [X]
 
The number of shares outstanding of the registrant’s Class A Common Stock as of the latest practicable date, with no par value and a stated value of $0.0292 per share, was 46,189,068 at April 13, 2018.
 
The number of shares outstanding of the registrant’s Class B Common Stock as of the latest practicable date, with no par value and a stated value of $70 per share, was 2,542 at April 13, 2018.



 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

2


PART I. FINANCIAL INFORMATION

ITEM 1.
FINANCIAL STATEMENTS

ERIE INDEMNITY COMPANY
STATEMENTS OF OPERATIONS (UNAUDITED)
(dollars in thousands, except per share data)

 
 
Three months ended
 
 
March 31,
 
 
2018
 
2017
Operating revenue
 
 

 
 

Management fee revenue - policy issuance and renewal services, net
 
$
405,978

 
$
392,058

Management fee revenue - administrative services, net
 
13,074

 

Administrative services reimbursement revenue
 
145,963

 

Service agreement revenue
 
7,145

 
7,258

Total operating revenue
 
572,160

 
399,316

 
 
 
 
 
Operating expenses
 
 
 
 
Cost of operations - policy issuance and renewal services
 
348,630

 
332,376

Cost of operations - administrative services
 
145,963

 

Total operating expenses
 
494,593

 
332,376

Operating income
 
77,567

 
66,940

 
 
 
 
 
Investment income
 
 
 
 
Net investment income
 
6,820

 
5,981

Net realized investment (losses) gains
 
(465
)
 
516

Net impairment losses recognized in earnings
 
0

 
(121
)
Equity in (losses) earnings of limited partnerships
 
(192
)
 
213

Total investment income
 
6,163

 
6,589

 
 
 
 
 
Interest expense, net
 
553

 
166

Other income (expense)
 
44

 
(409
)
Income before income taxes
 
83,221

 
72,954

Income tax expense
 
17,463

 
25,078

Net income
 
$
65,758

 
$
47,876

 
 
 
 
 
 
 
 
 
 
Net income per share
 
 

 
 

Class A common stock – basic
 
$
1.41

 
$
1.03

Class A common stock – diluted
 
$
1.26

 
$
0.91

Class B common stock – basic and diluted
 
$
212

 
$
154

 
 
 
 
 
Weighted average shares outstanding – Basic
 
 

 
 

Class A common stock
 
46,187,908

 
46,188,522

Class B common stock
 
2,542

 
2,542

 
 
 
 
 
Weighted average shares outstanding – Diluted
 
 

 
 

Class A common stock
 
52,310,628

 
52,408,560

Class B common stock
 
2,542

 
2,542

 
 
 
 
 
Dividends declared per share
 
 

 
 

Class A common stock
 
$
0.8400

 
$
0.7825

Class B common stock
 
$
126.000

 
$
117.375

 
 
See accompanying notes to Financial Statements. See Note 11, "Accumulated Other Comprehensive Income (Loss)", for amounts reclassified out of accumulated other comprehensive income (loss) into the Statements of Operations. 

3


ERIE INDEMNITY COMPANY
STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)
(in thousands)

 
 
Three months ended
 
 
March 31,
 
 
2018
 
2017
Net income
 
$
65,758

 
$
47,876

 
 
 
 
 
Other comprehensive (loss) income, net of tax
 
 

 
 

Change in unrealized holding (losses) gains on available-for-sale securities
 
(5,427
)
 
1,521

 
 
 
 
 
Comprehensive income
 
$
60,331

 
$
49,397

 
See accompanying notes to Financial Statements. See Note 11, "Accumulated Other Comprehensive Income (Loss)", for amounts reclassified out of accumulated other comprehensive income (loss) into the Statements of Operations.

4


ERIE INDEMNITY COMPANY
STATEMENTS OF FINANCIAL POSITION
(dollars in thousands, except per share data)

 
 
 
March 31,
 
December 31,
 
 
2018
 
2017
Assets
 
(Unaudited)
 
 
Current assets:
 
 
 
 
Cash and cash equivalents
 
$
119,627

 
$
215,721

Available-for-sale securities
 
96,574

 
71,190

Receivables from Erie Insurance Exchange and affiliates
 
415,343

 
418,328

Prepaid expenses and other current assets
 
43,061

 
34,890

Federal income taxes recoverable
 
14,716

 
29,900

Note receivable from Erie Family Life Insurance Company
 
25,000

 
25,000

Accrued investment income
 
6,425

 
6,853

Total current assets
 
720,746

 
801,882

 
 
 
 
 
Available-for-sale securities
 
633,230

 
687,523

Equity securities
 
12,583

 

Limited partnership investments
 
44,114

 
45,122

Fixed assets, net
 
88,448

 
83,149

Deferred income taxes, net
 
29,055

 
19,390

Other assets
 
45,300

 
28,793

Total assets
 
$
1,573,476

 
$
1,665,859

 
 
 
 
 
Liabilities and shareholders' equity
 
 
 
 
Current liabilities:
 
 
 
 
Commissions payable
 
$
240,848

 
$
228,124

Agent bonuses
 
30,232

 
122,528

Accounts payable and accrued liabilities
 
95,789

 
104,533

Dividends payable
 
39,119

 
39,116

Contract liability
 
31,951

 

Deferred executive compensation
 
9,710

 
15,605

Total current liabilities
 
447,649

 
509,906

 
 
 
 
 
Defined benefit pension plans
 
176,598

 
207,530

Employee benefit obligations
 
313

 
423

Contract liability
 
16,910

 

Deferred executive compensation
 
16,096

 
14,452

Long-term borrowings
 
74,726

 
74,728

Other long-term liabilities
 
1,029

 
1,476

Total liabilities
 
733,321

 
808,515

 
 
 
 
 
Shareholders’ equity
 
 
 
 
Class A common stock, stated value $0.0292 per share; 74,996,930 shares authorized; 68,299,200 shares issued; 46,189,068 shares outstanding
 
1,992

 
1,992

Class B common stock, convertible at a rate of 2,400 Class A shares for one Class B share, stated value $70 per share; 3,070 shares authorized; 2,542 shares issued and outstanding
 
178

 
178

Additional paid-in-capital
 
16,461

 
16,470

Accumulated other comprehensive loss
 
(161,486
)
 
(156,059
)
Retained earnings
 
2,129,100

 
2,140,853

Total contributed capital and retained earnings
 
1,986,245

 
2,003,434

Treasury stock, at cost; 22,110,132 shares held
 
(1,157,331
)
 
(1,155,668
)
Deferred compensation
 
11,241

 
9,578

Total shareholders’ equity
 
840,155

 
857,344

Total liabilities and shareholders’ equity
 
$
1,573,476

 
$
1,665,859

 
See accompanying notes to Financial Statements. 

5


ERIE INDEMNITY COMPANY
STATEMENTS OF CASH FLOWS (UNAUDITED)
(in thousands)

 
 
Three months ended
 
 
March 31,
 
 
2018
 
2017
Cash flows from operating activities
 
 
 
 
Management fee received
 
$
418,897

 
$
389,346

Administrative services reimbursements received
 
150,422

 

Service agreement fee received
 
7,145

 
7,258

Net investment income received
 
8,951

 
7,553

Limited partnership distributions
 
426

 
643

Decrease in reimbursements collected from affiliates
 

 
(11,066
)
Commissions paid to agents
 
(192,803
)
 
(182,652
)
Agents bonuses paid
 
(122,607
)
 
(111,275
)
Salaries and wages paid
 
(54,668
)
 
(47,442
)
Pension contribution and employee benefits paid
 
(49,199
)
 
(26,557
)
General operating expenses paid
 
(59,033
)
 
(61,000
)
Administrative services expenses paid
 
(146,935
)
 

Income taxes (paid) recovered
 
(276
)
 
234

Interest paid
 
(550
)
 
(164
)
Net cash used in operating activities
 
(40,230
)
 
(35,122
)
 
 
 
 
 
Cash flows from investing activities
 
 
 
 
Purchase of investments:
 
 
 
 
Available-for-sale securities
 
(77,263
)
 
(65,521
)
Equity securities
 
(1,035
)
 

Limited partnerships
 
(31
)
 
(111
)
Proceeds from investments:
 
 
 
 
Available-for-sale securities sales
 
57,717

 
16,633

Available-for-sale securities maturities/calls
 
28,473

 
43,460

Equity securities
 
1,055

 

Limited partnerships
 
910

 
3,396

Net purchase of fixed assets
 
(8,691
)
 
(3,551
)
Net distributions on agent loans
 
(17,874
)
 
(1,387
)
Net cash used in investing activities
 
(16,739
)
 
(7,081
)
 
 
 
 
 
Cash flows from financing activities
 
 
 
 
Dividends paid to shareholders
 
(39,116
)
 
(36,441
)
Net costs from long-term borrowings
 
(9
)
 
(10
)
Net cash used in financing activities
 
(39,125
)
 
(36,451
)
 
 
 
 
 
Net decrease in cash and cash equivalents
 
(96,094
)
 
(78,654
)
Cash and cash equivalents, beginning of period
 
215,721

 
189,072

Cash and cash equivalents, end of period
 
$
119,627

 
$
110,418

  
See accompanying notes to Financial Statements.

6


NOTES TO FINANCIAL STATEMENTS (UNAUDITED)
 
Note 1.  Nature of Operations
 
Erie Indemnity Company ("Indemnity", "we", "us", "our") is a publicly held Pennsylvania business corporation that has since its incorporation in 1925 served as the attorney-in-fact for the subscribers (policyholders) at the Erie Insurance Exchange ("Exchange").  The Exchange, which also commenced business in 1925, is a Pennsylvania-domiciled reciprocal insurer that writes property and casualty insurance. We function solely as the management company and all insurance operations are performed by the Exchange.
 
Our primary function as attorney-in-fact is to perform policy issuance and renewal services on behalf of the subscribers at the Exchange. We also act as attorney-in-fact on behalf of the Exchange with respect to all claims handling and investment management services, as well as the service provider for all claims handling, life insurance, and investment management services for its insurance subsidiaries, collectively referred to as "administrative services". Acting as attorney-in-fact in these two capacities is done in accordance with a subscriber's agreement (a limited power of attorney) executed individually by each subscriber (policyholder), which appoints us as their common attorney-in-fact to transact certain business on their behalf.  Pursuant to the subscriber's agreement for acting as attorney-in-fact in these two capacities, we earn a management fee calculated as a percentage of the direct and assumed premiums written by the Exchange.

The policy issuance and renewal services we provide to the Exchange are related to the sales, underwriting and issuance of policies. The sales related services we provide include agent compensation and certain sales and advertising support services. Agent compensation includes scheduled commissions to agents based upon premiums written as well as additional commissions and bonuses to agents, which are earned by achieving targeted measures. The underwriting services we provide include underwriting and policy processing. The remaining services we provide include customer service and administrative support. We also provide information technology services that support all the functions listed above. Included in these expenses are allocations of costs for departments that support these policy issuance and renewal functions.

By virtue of its legal structure as a reciprocal insurer, the Exchange does not have any employees or officers. Therefore, it enters into contractual relationships by and through an attorney-in-fact. Indemnity serves as the attorney-in-fact on behalf of the Exchange with respect to its administrative services. The Exchange's insurance subsidiaries also utilize Indemnity for these services in accordance with the service agreements between each of the subsidiaries and Indemnity. Claims handling services include costs incurred in the claims process, including the adjustment, investigation, defense, recording and payment functions. Life insurance management services include costs incurred in the management and processing of life insurance business. Investment management services are related to investment trading activity, accounting and all other functions attributable to the investment of funds. Included in these expenses are allocations of costs for departments that support these administrative functions. The amounts incurred for these services are reimbursed to Indemnity at cost in accordance with the subscriber's agreement and the service agreements. State insurance regulations require that intercompany service agreements and any material amendments be approved in advance by the state insurance department.

Our results of operations are tied to the growth and financial condition of the Exchange. If any events occurred that impaired the Exchange’s ability to grow or sustain its financial condition, including but not limited to reduced financial strength ratings, disruption in the independent agency relationships, significant catastrophe losses, or products not meeting customer demands, the Exchange could find it more difficult to retain its existing business and attract new business. A decline in the business of the Exchange almost certainly would have as a consequence a decline in the total premiums paid and a correspondingly adverse effect on the amount of the management fees we receive. We also have an exposure to a concentration of credit risk related to the unsecured receivables due from the Exchange for its management fee. See Note 12, "Concentrations of Credit Risk".



7


Note 2.  Significant Accounting Policies

Basis of presentation
The accompanying unaudited financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP") for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2018 are not necessarily indicative of the results that may be expected for the year ending December 31, 2018. For further information, refer to the financial statements and footnotes included in our Form 10-K for the year ended December 31, 2017 as filed with the Securities and Exchange Commission on February 22, 2018.

Use of estimates
The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.

Recently adopted accounting standards
We adopted Accounting Standards Codification 606, "Revenue from Contracts with Customers" ("ASC 606") on January 1, 2018, using the modified retrospective method applied to all contracts. We recognized the cumulative effect of initially adopting ASC 606 as an adjustment to the opening balance of retained earnings at January 1, 2018. The comparative information for periods preceding January 1, 2018 has not been restated and continues to be reported under the accounting standards in effect for those periods.
Under ASC 606, we determined that we have two performance obligations under the subscriber’s agreement. The first performance obligation is providing policy issuance and renewal services. The second performance obligation is acting as the attorney-in-fact on behalf of the Exchange, as well as the service provider for its insurance subsidiaries, with respect to all administrative services. Therefore, upon adoption of ASC 606 beginning January 1, 2018, the management fee earned per the subscriber’s agreement, currently 25% of all direct and assumed premiums written by the Exchange, will be allocated between the two performance obligations. Prior to the adoption of ASC 606, the entire management fee was allocated to the policy issuance and renewal services. Additionally, the expenses we incur and related reimbursements we receive related to the administrative services will be presented gross in our Statement of Operations effective January 1, 2018. There was no significant impact to service agreement revenue upon adoption of ASC 606.
Revenue allocated to the policy issuance and renewal services continues to be recognized at the time of policy issuance or renewal because it is at the time of policy issuance or renewal when the economic benefits of the service Indemnity provides (i.e. the substantially completed policy issuance or renewal service) and the control of the promised asset (i.e. the executed insurance policy) transfers to the customer. A significant portion of the management fee is currently allocated to this performance obligation and therefore, the related revenue recognition pattern for the vast majority of our revenues will remain unchanged.
The revenue allocated to the second performance obligation will be recognized over several years in correlation with the costs incurred because the economic benefit of the services provided (i.e. management of the administrative services) transfers to the customer over a period of time. The amounts incurred for these services are reimbursed to Indemnity at cost in accordance with the subscriber's agreement and the service agreements. On January 1, 2018, we established a contract liability of $48.5 million representing the portion of revenue not yet earned related to the administrative services to be provided in subsequent years. We recorded a related deferred tax asset of $10.2 million and a cumulative effect adjustment that reduced retained earnings by $38.3 million. The adoption of ASC 606 changed the presentation of our Statement of Cash Flows, but had no net impact to our cash flows.

8


The cumulative effect of the changes made to our Statement of Financial Position at January 1, 2018 were as follows:
(in thousands)
 
Balance at December 31, 2017
Adjustments due to ASC 606
Balance at January 1, 2018
Statement of Financial Position:
 
 
 
 
Assets
 
 
 
 
Deferred tax asset
 
$
19,390

$
10,188

$
29,578

Liabilities
 
 
 
 
Contract liability
 

48,514

48,514

Equity
 
 
 
 
Retained earnings
 
2,140,853

(38,326
)
2,102,527



The impact of adoption on our Statement of Financial Position and Statement of Operations at March 31, 2018 was as follows:
 
 
March 31, 2018
(in thousands)
 
As Reported
Balances without ASC 606
Impact of Change
Higher/(Lower)
 
 
(Unaudited)
Statement of Financial Position:
 
 
 
 
Assets
 
 
 
 
Deferred tax asset
 
$
29,055

$
18,794

$
10,261

Liabilities
 
 
 
 
Contract liability
 
48,861


48,861

Equity
 
 
 
 
Retained earnings
 
2,129,100

2,167,700

(38,600
)
 
 
 
 
 
Statement of Operations:
 
 
 
 
Management fee revenue allocated to policy issuance and renewal services, gross
 
$
407,236

$
420,699

$
(13,463
)
Less: change in allowance for management fee returned on cancelled policies
 
(1,258
)
(1,300
)
42

Management fee revenue allocated to policy issuance and renewal services, net
 
$
405,978

$
419,399

$
(13,421
)
 
 
 
 
 
 
 
 
 
 
Management fee revenue allocated to administrative services, gross
 
$
13,088

$

$
13,088

Less: change in allowance for management fee returned on cancelled policies
 
(14
)

(14
)
Management fee revenue allocated to administrative services, net
 
13,074


13,074

Administrative services reimbursement revenue
 
145,963


145,963

Total revenue allocated to administrative services
 
$
159,037

$

$
159,037

 
 
 
 
 
 
 
 
 
 
Administrative services expenses
 
$
145,963

$

$
145,963



In March 2017, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2017-07, "Compensation-Retirement Benefits", which requires the service cost component of net benefit costs to be reported with other compensation costs arising from services rendered by the pertinent employees during the period. The other components of net benefit costs are required to be presented separately from the service cost component and outside of income from operations on a retrospective basis. This amendment also allows only the service cost component to be eligible for capitalization, when applicable, prospectively after the effective date. ASU 2017-07 is effective for interim and annual periods beginning after December 15, 2017. We adopted this guidance effective January 1, 2018 and have included the other components of net benefit costs in "Other income (expense)" in the Statements of Operations and conformed the prior-period presentation. The adoption of this guidance did not have a material impact on the presentation of our financial statements or related disclosures.

9


In January 2016, the FASB issued ASU 2016-01, "Financial Instruments-Overall". ASU 2016-01 revises the accounting related to the classification and measurement of investments in equity securities and the presentation of certain fair value changes for financial liabilities measured at fair value. ASU 2016-01 is effective for interim and annual reporting periods beginning after December 15, 2017. We adopted this guidance on a prospective basis effective January 1, 2018. The adoption of this guidance resulted in reclassifying unrealized losses, net of tax, on equity securities from accumulated other comprehensive loss to retained earnings, which reduced retained earnings by $0.1 million at January 1, 2018. Equity securities are now presented separately in our Statement of Financial Position at March 31, 2018. Our disclosures were prepared in accordance with this guidance.

Recently issued accounting standards
In June 2016, the FASB issued ASU 2016-13, "Financial Instruments-Credit Losses", which requires financial assets measured at amortized cost to be presented at the net amount expected to be collected through the use of a new forward-looking expected loss model and credit losses relating to available-for-sale debt securities to be recognized through an allowance for credit losses. ASU 2016-13 is effective for interim and annual reporting periods beginning after December 15, 2019. Early adoption for interim and annual periods beginning after December 15, 2018 is permitted. We have evaluated the impact of this guidance on our invested assets. Our investments are not measured at amortized cost, and therefore do not require the use of a new expected loss model. Our available-for-sale debt securities will continue to be monitored for credit losses which would be reflected as an allowance for credit losses rather than a reduction of the carrying value of the asset. The other material financial assets subject to this guidance include our receivables from Erie Insurance Exchange and its subsidiaries. Given the financial strength of the Exchange, demonstrated by its strong surplus position and industry ratings, it is unlikely these receivables would have significant, if any, credit loss exposure. We do not expect a material impact on our financial statements or related disclosures as a result of this guidance.

In February 2016, the FASB issued ASU 2016-02, "Leases", which requires lessees to recognize assets and liabilities arising from operating leases on the statement of financial position and to disclose key information about leasing arrangements. ASU 2016-02 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Currently ASU 2016-02 requires leases to be recognized and measured at the beginning of the earliest period presented using a modified retrospective approach. In January 2018, the FASB issued a proposed ASU that would allow entities to recognize the cumulative effect adjustment in the year of adoption rather than the earliest period presented. Under existing guidance, we recognize lease expense as a component of operating expenses in the Statements of Operations. We are evaluating our lease contracts to determine those that qualify for treatment as leases under the new guidance and the impact to our financial statements and disclosures.

Recognition of management fee revenue
We earn management fees from the Exchange under the subscriber’s agreement for services provided. Pursuant to the subscriber’s agreement, we may retain up to 25% of all direct and assumed premiums written by the Exchange. The management fee rate is set at least annually by our Board of Directors. The management fee revenue is calculated by multiplying the management fee rate by the direct and assumed premiums written by the Exchange. Upon adoption of ASC 606 beginning January 1, 2018, we determined we have two performance obligations under the subscriber’s agreement. The first performance obligation is to provide policy issuance and renewal services. The second performance obligation is acting as the attorney-in-fact with respect to the administrative services. Beginning January 1, 2018, our management fee revenue is allocated to these two performance obligations. Prior to the adoption of ASC 606, the entire management fee was allocated to the policy issuance and renewal services.

Management fee revenue allocated to the policy issuance and renewal services is recognized at the time of policy issuance or renewal, because it is at the time of policy issuance or renewal when the economic benefit of the service we provide (the substantially completed policy issuance or renewal service) and the control of the promised asset (the executed insurance policy) transfers to the customer.

Management fee revenue allocated to the second performance obligation relates to us acting as the attorney-in-fact on behalf of the Exchange, as well as the service provider for its insurance subsidiaries, with respect to the administrative services and is recognized over a four-year period representing the time over which the economic benefit of the services provided (i.e. management of the administrative services) transfers to the customer.

Administrative services
By virtue of its legal structure as a reciprocal insurer, the Exchange does not have any employees or officers. Therefore, it enters into contractual relationships by and through an attorney-in-fact. Indemnity serves as the attorney-in-fact on behalf of the Exchange with respect to its administrative services in accordance with the subscriber's agreement. The Exchange's insurance subsidiaries also utilize Indemnity for these services in accordance with the service agreements between each of the

10


subsidiaries and Indemnity. Claims handling services include costs incurred in the claims process, including the adjustment, investigation, defense, recording and payment functions. Life insurance management services include costs incurred in the management and processing of life insurance business. Investment management services are related to investment trading activity, accounting and all other functions attributable to the investment of funds. Included in these expenses are allocations of costs for departments that support these administrative functions. Common overhead expenses and certain service department costs incurred by us on behalf of the Exchange and its insurance subsidiaries are reimbursed by the proper entity based upon appropriate utilization statistics (employee count, square footage, vehicle count, project hours, etc.) specifically measured to accomplish proportional allocations, which we believe are reasonable. Prior to the adoption of ASC 606, we recorded the reimbursements we receive for the administrative services expenses as receivables from the Exchange and its subsidiaries with a corresponding reduction to our expenses. Upon adoption of ASC 606 on January 1, 2018, the expenses we incur and related reimbursements we receive for administrative services are presented gross in our Statement of Operations. Reimbursements are settled on a monthly basis. The amounts incurred for these services are reimbursed to Indemnity at cost in accordance with the subscriber's agreement and the service agreements. State insurance regulations require that intercompany service agreements and any material amendments be approved in advance by the state insurance department.

Reclassifications
Certain amounts previously reported in the 2017 financial statements have been reclassified for comparative purposes to conform to the current period’s presentation.  Such reclassifications resulted from new accounting guidance and only affected the Statements of Operations.  Most notably, "Commissions", "Salaries and employee benefits", and "All other operating expenses" have been combined within "Cost of operations - policy issuance and renewal services" in the Statements of Operations (See Note 3, "Revenue").  These reclassifications had no effect on previously reported net income.



11


Note 3.  Revenue

The majority of our revenue is derived from the subscriber’s agreement between us and the subscribers (policyholders) at the Exchange. Pursuant to the subscriber’s agreement, we earn a management fee calculated as a percentage, not to exceed 25%, of all direct and assumed written premiums of the Exchange. We account for management fee revenue earned under the subscriber’s agreement in accordance with ASC 606, which we adopted on January 1, 2018, using the modified retrospective method. See Note 2, "Significant Accounting Policies" for further discussion of the adoption, including the impact on our financial statements.
We allocate a portion of our management fee revenue, currently 25% of the direct and assumed written premiums of the Exchange, between the two performance obligations we have under the subscriber’s agreement. The first performance obligation is to provide policy issuance and renewal services to the subscribers (policyholders) at the Exchange, and the second is to act as attorney-in-fact on behalf of the Exchange, as well as the service provider for its insurance subsidiaries, with respect to all administrative services. The transaction price, including management fee revenue and administrative service reimbursement revenue, is allocated based on the estimated standalone selling prices developed using industry information and other available information for similar services.

The first performance obligation is to provide policy issuance and renewal services that result in executed insurance policies between the Exchange or one of its insurance subsidiaries and the subscriber (policyholder). Our customer, the subscriber (policyholder), receives economic benefits when substantially all the policy issuance or renewal services are complete and an insurance policy is issued or renewed by the Exchange or one of its insurance subsidiaries. It is at the time of policy issuance or renewal that the allocated portion of revenue is recognized.

The Exchange, by virtue of its legal structure as a reciprocal insurer, does not have any employees or officers. Therefore, it enters into contractual relationships by and through an attorney-in-fact. Indemnity serves as the attorney-in-fact on behalf of the Exchange with respect to its administrative services in accordance with the subscriber's agreement. The Exchange's insurance subsidiaries also utilize Indemnity for these services in accordance with the service agreements between each of the subsidiaries and Indemnity. Collectively, these services represent a second performance obligation under the subscriber’s agreement and the service agreements. The revenue allocated to this performance obligation is recognized over time as these services are provided. The portion of revenue not yet earned is recorded as a contract liability in the Statement of Financial Position. We recorded a contract liability of $48.5 million at January 1, 2018, upon adoption of ASC 606. The management fee revenue recognized as earned for these services for the three months ended March 31, 2018 was $13.1 million. Beginning with the adoption of ASC 606 on January 1, 2018, the administrative services expenses we incur and the related reimbursements we receive are recorded gross in the Statement of Operations.

Indemnity records a receivable from the Exchange for management fee revenue when the premium is written or assumed by the Exchange. Indemnity collects the management fee from the Exchange when the Exchange collects the premiums from the subscribers (policyholders). As the Exchange issues policies with annual terms only, cash collections generally occur within one year.

A constraining estimate exists around the management fee received as consideration related to the potential for management fee to be returned if a policy were to be cancelled mid-term. Management fees are returned to the Exchange when policyholders cancel their insurance coverage mid-term and unearned premiums are refunded to them. We maintain an estimated allowance to reduce the management fee to its estimated net realizable value to account for the potential of mid-term policy cancellations based on historical cancellation rates. This estimated allowance has been allocated between the two performance obligations consistent with the revenue allocation proportions.

The following table disaggregates revenue by our two performance obligations:
 
 
Three months ended March 31,
(in thousands)
 
2018
2017
Management fee revenue - policy issuance and renewal services
 
$
405,978

$
392,058

 
 
 
 
Management fee revenue - administrative services
 
13,074


Administrative services reimbursement revenue
 
145,963


Total administrative services
 
$
159,037

$

 



12


Note 4.  Earnings Per Share
 
Class A and Class B basic earnings per share and Class B diluted earnings per share are calculated under the two-class method. The two-class method allocates earnings to each class of stock based upon its dividend rights.  Class B shares are convertible into Class A shares at a conversion ratio of 2,400 to 1. See Note 10, "Capital Stock".

Class A diluted earnings per share are calculated under the if-converted method, which reflects the conversion of Class B shares to Class A shares. Diluted earnings per share calculations include the dilutive effect of assumed issuance of stock-based awards under compensation plans that have the option to be paid in stock using the treasury stock method.

A reconciliation of the numerators and denominators used in the basic and diluted per-share computations is presented as follows for each class of common stock: 
 
 
Three months ended March 31,
 
 
2018
 
2017
(dollars in thousands, except per share data)
 
Allocated net income (numerator)
 
Weighted shares (denominator)
 
Per-share amount
 
Allocated net income (numerator)
 
Weighted shares (denominator)
 
Per-share amount
Class A – Basic EPS:
 
 
 
 
 
 
 
 
 
 
 
 
Income available to Class A stockholders
 
$
65,220

 
46,187,908

 
$
1.41

 
$
47,484

 
46,188,522

 
$
1.03

Dilutive effect of stock-based awards
 
0

 
21,920

 

 
0

 
119,238

 

Assumed conversion of Class B shares
 
538

 
6,100,800

 

 
392

 
6,100,800

 

Class A – Diluted EPS:
 
 
 
 
 
 
 
 
 
 
 
 
Income available to Class A stockholders on Class A equivalent shares
 
$
65,758

 
52,310,628

 
$
1.26

 
$
47,876

 
52,408,560

 
$
0.91

Class B – Basic and diluted EPS:
 
 
 
 
 
 
 
 
 
 
 
 
Income available to Class B stockholders
 
$
538

 
2,542

 
$
212

 
$
392

 
2,542

 
$
154

 
 
 
 
 
 
 
 
 
 
 
 
 

13


Note 5. Fair Value
 
Our available-for-sale debt securities and equity securities are recorded at fair value, which is the price that would be received to sell the asset in an orderly transaction between willing market participants as of the measurement date.
 
Valuation techniques used to derive the fair value of our available-for-sale debt securities and equity securities are based upon observable and unobservable inputs.  Observable inputs reflect market data obtained from independent sources.  Unobservable inputs reflect our own assumptions regarding fair market value for these securities.  Although virtually all of our prices are obtained from third party sources, we also perform an internal pricing review on outliers, which include securities with price changes inconsistent with current market conditions. Financial instruments are categorized based upon the following characteristics or inputs to the valuation techniques:
 
Level 1 – Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity can access at the measurement date.

Level 2 – Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

Level 3 – Unobservable inputs for the asset or liability.
 
Estimates of fair values for our investment portfolio are obtained primarily from a nationally recognized pricing service.  Our Level 1 category includes those securities valued using an exchange traded price provided by the pricing service.  The methodologies used by the pricing service that support a Level 2 classification of a financial instrument include multiple verifiable, observable inputs including benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data.  Pricing service valuations for Level 3 securities are based upon proprietary models and are used when observable inputs are not available or in illiquid markets.
 
In limited circumstances we adjust the price received from the pricing service when, in our judgment, a better reflection of fair value is available based upon corroborating information and our knowledge and monitoring of market conditions such as a disparity in price of comparable securities and/or non-binding broker quotes.  In other circumstances, certain securities are internally priced because prices are not provided by the pricing service.
 
We perform continuous reviews of the prices obtained from the pricing service.  This includes evaluating the methodology and inputs used by the pricing service to ensure that we determine the proper classification level of the financial instrument.  Price variances, including large periodic changes, are investigated and corroborated by market data.  We have reviewed the pricing methodologies of our pricing service as well as other observable inputs, such as market data, and transaction volumes and believe that the prices adequately consider market activity in determining fair value. 
 
When a price from the pricing service is not available, values are determined by obtaining broker/dealer quotes and/or market comparables.  When available, we obtain multiple quotes for the same security.  The ultimate value for these securities is determined based upon our best estimate of fair value using corroborating market information.  Our evaluation includes the consideration of benchmark yields, reported trades, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data.


14


The following tables present our fair value measurements on a recurring basis by asset class and level of input:
 
 
 
At March 31, 2018
 
 
Fair value measurements using:
(in thousands)
 
Total
 
Quoted prices in
active markets for identical assets
Level 1
 
Observable inputs
Level 2
 
Unobservable inputs
Level 3
Available-for-sale securities:
 
 
 
 
 
 
 
 
U.S. treasury
 
$
36,464

 
$
0

 
$
36,464

 
$
0

States & political subdivisions
 
261,152

 
0

 
261,152

 
0

Foreign government securities
 
501

 
0

 
501

 
0

Corporate debt securities
 
299,599

 
0

 
293,290

 
6,309

Residential mortgage-backed securities
 
24,110

 
0

 
24,110

 
0

Commercial mortgage-backed securities
 
33,675

 
0

 
33,675

 
0

Collateralized debt obligations
 
71,305

 
0

 
71,305

 
0

Other debt securities
 
2,998

 
0

 
2,998

 
0

Total available-for-sale securities
 
729,804

 
0

 
723,495

 
6,309

Equity securities:
 
 
 
 
 
 
 
 
Nonredeemable preferred stock - financial services sector
 
12,583

 
1,993

 
10,590

 
0

Total equity securities
 
12,583

 
1,993

 
10,590

 
0

Other investments (1)
 
4,429

 

 

 

Total
 
$
746,816

 
$
1,993

 
$
734,085

 
$
6,309


 
 
At December 31, 2017
 
 
Fair value measurements using:
(in thousands)
 
Total
 
Quoted prices in
active markets for identical assets
Level 1
 
Observable inputs
Level 2
 
Unobservable inputs
Level 3
Available-for-sale securities:
 
 
 
 
 
 
 
 
U.S. treasury
 
$
11,734

 
$
0

 
$
11,734

 
$
0

States & political subdivisions
 
259,264

 
0

 
259,264

 
0

Foreign government securities
 
503

 
0

 
503

 
0

Corporate debt securities
 
346,523

 
0

 
338,644

 
7,879

Residential mortgage-backed securities
 
25,571

 
0

 
25,571

 
0

Commercial mortgage-backed securities
 
32,804

 
0

 
32,804

 
0

Collateralized debt obligations
 
58,034

 
0

 
55,834

 
2,200

Other debt securities
 
11,528

 
0

 
11,528

 
0

Total fixed maturities
 
745,961

 
0

 
735,882

 
10,079

Nonredeemable preferred stock - financial services sector
 
11,659

 
2,015

 
9,644

 
0

Nonredeemable preferred stock - utilities sector
 
1,093

 
0

 
1,093

 
0

Total available-for-sale securities
 
758,713

 
2,015

 
746,619

 
10,079

Other investments (1)
 
4,816

 

 

 

Total
 
$
763,529

 
$
2,015

 
$
746,619

 
$
10,079


(1)          Other investments measured at fair value represent real estate funds included on the balance sheet as limited partnership investments that are reported under the fair value option using the net asset value practical expedient. These amounts are not required to be categorized in the fair value hierarchy. The investments can never be redeemed with the funds. Instead, distributions are received when liquidation of the underlying assets of the funds occur. It is estimated that the underlying assets will generally be liquidated between 5 and 10 years from the inception of the funds. The fair value of these investments is based on the net asset value (NAV) information provided by the general partner. Fair value is based on our proportionate share of the NAV based on the most recent partners' capital statements received from the general partners, which is generally one quarter prior to our balance sheet date. These values are then analyzed to determine if the NAV represents fair value at our balance sheet date, with adjustment being made where appropriate. We consider observable market data and perform a review validating the appropriateness of the NAV at each balance sheet date. It is likely that all of the investments will be redeemed at a future date for an amount different than the NAV of our ownership interest in partners' capital as of March 31, 2018 and December 31, 2017. During the three months ended March 31, 2018, no contributions were made and no distributions were received from these investments. During the year ended December 31, 2017, no contributions were made and distributions totaling $0.5 million were received from these investments. There were no unfunded commitments related to the investments as of March 31, 2018 and December 31, 2017.



15


We review the fair value hierarchy classifications each reporting period.  Transfers between hierarchy levels may occur due to changes in available market observable inputs. Transfers into and out of level classifications in 2017 are reported as having occurred at the beginning of the quarter in which the transfers occurred. Effective January 1, 2018, we changed our policy to recognize transfers as occurring at the end of the quarter in which the transfers occurred. This change is applied prospectively due to the immaterial impact on prior year disclosures.

There were no transfers between Level 1 and Level 2 for the three months ended March 31, 2018 and 2017.

Level 3 Assets – Year-to-Date Change:
(in thousands)
 
Beginning balance at December 31, 2017
 
Included in earnings(1)
 
Included
in other comprehensive
income
 
Purchases
 
Sales
 
Transfers into Level 3(2)
 
Transfers out of Level 3(2)
 
Ending balance at March 31, 2018
Available-for-sale securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
7,879

 
$
(9
)
 
$
5

 
$
0

 
$
(493
)
 
$
2,412

 
$
(3,485
)
 
$
6,309

Collateralized debt obligations
 
2,200

 
0

 
7

 
0

 
0

 
0

 
(2,207
)
 
0

Total Level 3 available-for-sale securities
 
$
10,079

 
$
(9
)
 
$
12

 
$
0

 
$
(493
)
 
$
2,412

 
$
(5,692
)
 
$
6,309



Level 3 Assets – Year-to-Date Change:
(in thousands)
 
Beginning balance at December 31, 2016
 
Included in earnings(1)
 
Included
in other
comprehensive
income
 
Purchases
 
Sales
 
Transfers into Level 3(2)
 
Transfers out of Level 3(2)
 
Ending balance at March 31, 2017
Available-for-sale securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
9,352

 
$
(50
)
 
$
(25
)
 
$
1,871

 
$
(1,849
)
 
$
2,185

 
$
(1,681
)
 
$
9,803

Total Level 3 available-for-sale securities
 
$
9,352

 
$
(50
)
 
$
(25
)
 
$
1,871

 
$
(1,849
)
 
$
2,185

 
$
(1,681
)
 
$
9,803

 
(1)
These amounts are reported in the Statements of Operations as net investment income and net realized investment gains (losses) for the each of the periods presented above.
(2)
Transfers into and/or (out) of Level 3 are primarily attributable to the availability of market observable information and the re-evaluation of the observability of pricing inputs.


Quantitative and Qualitative Disclosures about Unobservable Inputs

When a non-binding broker quote was the only input available, the security was classified within Level 3. Use of non-binding broker quotes totaled $6.3 million at March 31, 2018. The unobservable inputs are not reasonably available to us.

The following table presents our fair value measurements on a recurring basis by pricing source:
 
 
At March 31, 2018
(in thousands)
 
Total
 
Level 1
 
Level 2
 
Level 3
Available-for-sale securities priced via pricing services
 
$
729,804

 
$
0

 
$
723,495

 
$
6,309

Equity securities priced via pricing services
 
12,583

 
1,993

 
10,590

 
0

Other investments priced via unobservable inputs (1)
 
4,429

 

 

 

Total
 
$
746,816

 
$
1,993

 
$
734,085

 
$
6,309

 
(1)
Other investments measured at fair value represent real estate funds included on the balance sheet as limited partnership investments that are reported under the fair value option using the NAV practical expedient. These amounts are not required to be categorized in the fair value hierarchy. The fair value of these investments is based on the NAV information provided by the general partner.


There were no assets measured at fair value on a nonrecurring basis during the three months ended March 31, 2018.

16


Note 6.  Investments
 
Available-for-sale securities
The following tables summarize the cost and fair value of our available-for-sale securities:
 
 
 
At March 31, 2018
 (in thousands)
 
Amortized
cost
 
Gross unrealized gains
 
Gross unrealized losses
 
Estimated fair value
Available-for-sale securities:
 
 
 
 
 
 
 
 
U.S. treasury
 
$
36,740

 
$
0

 
$
276

 
$
36,464

States & political subdivisions
 
260,153

 
3,663

 
2,664

 
261,152

Foreign government securities
 
501

 
0

 
0

 
501

Corporate debt securities
 
302,395

 
1,008

 
3,804

 
299,599

Residential mortgage-backed securities
 
23,980

 
357

 
227

 
24,110

Commercial mortgage-backed securities
 
34,663

 
12

 
1,000

 
33,675

Collateralized debt obligations
 
71,200

 
206

 
101

 
71,305

Other debt securities
 
2,986

 
12

 
0

 
2,998

Total available-for-sale securities
 
$
732,618

 
$
5,258

 
$
8,072

 
$
729,804

 

 
 
At December 31, 2017
(in thousands)
 
Amortized
cost
 
Gross unrealized gains
 
Gross unrealized losses
 
Estimated fair value
Available-for-sale securities:
 
 
 
 
 
 
 
 
U.S. treasury
 
$
11,873

 
$
0

 
$
139

 
$
11,734

States & political subdivisions
 
254,533

 
5,351

 
620

 
259,264

Foreign government securities
 
501

 
2

 
0

 
503

Corporate debt securities
 
346,759

 
1,688

 
1,924

 
346,523

Residential mortgage-backed securities
 
25,324

 
371

 
124

 
25,571

Commercial mortgage-backed securities
 
33,475

 
26

 
697

 
32,804

Collateralized debt obligations
 
57,838

 
237

 
41

 
58,034

Other debt securities
 
11,496

 
32

 
0

 
11,528

Total fixed maturities
 
741,799

 
7,707

 
3,545

 
745,961

Nonredeemable preferred stock - financial services sector
 
11,719

 
15

 
75

 
11,659

Nonredeemable preferred stock - utilities sector
 
1,118

 
0

 
25

 
1,093

Total available-for-sale securities
 
$
754,636

 
$
7,722

 
$
3,645

 
$
758,713

 
 
The amortized cost and estimated fair value of available-for-sale securities at March 31, 2018, are shown below by remaining contractual term to maturity.  Mortgage-backed securities are allocated based upon stated maturity dates.  Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
 
 
 
At March 31, 2018
 
 
Amortized
 
Estimated
(in thousands)
 
cost
 
fair value
Due in one year or less
 
$
96,656

 
$
96,574

Due after one year through five years
 
254,866

 
255,157

Due after five years through ten years
 
258,775

 
257,096

Due after ten years
 
122,321

 
120,977

Total available-for-sale securities
 
$
732,618

 
$
729,804




17


Available-for-sale securities in a gross unrealized loss position are as follows.  Data is provided by length of time for securities in a gross unrealized loss position.
 
 
 
At March 31, 2018
 
 
Less than 12 months
 
12 months or longer
 
Total
(dollars in thousands)
 
Fair
value
 
Unrealized losses
 
Fair
value
 
Unrealized losses
 
Fair
 value
 
Unrealized losses
 
No. of holdings
Available-for-sale securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. treasury
 
$
34,984

 
$
232

 
$
1,480

 
$
44

 
$
36,464

 
$
276

 
5

States & political subdivisions
 
103,285

 
1,934

 
13,896

 
730

 
117,181

 
2,664

 
59

Corporate debt securities
 
180,493

 
3,290

 
28,812

 
514

 
209,305

 
3,804

 
438

Residential mortgage-backed securities
 
4,779

 
94

 
6,476

 
133

 
11,255

 
227

 
14

Commercial mortgage-backed securities
 
15,108

 
264

 
11,816

 
736

 
26,924

 
1,000

 
23

Collateralized debt obligations
 
27,463

 
101

 
0

 
0

 
27,463

 
101

 
18

Other debt securities
 
333

 
0

 
0

 
0

 
333

 
0

 
1

Total available-for-sale securities
 
$
366,445

 
$
5,915

 
$
62,480

 
$
2,157

 
$
428,925

 
$
8,072

 
558

Quality breakdown of available-for-sale securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Investment grade
 
$
286,647

 
$
3,671

 
$
58,721

 
$
1,693

 
$
345,368

 
$
5,364

 
194

Non-investment grade
 
79,798

 
2,244

 
3,759

 
464

 
83,557

 
2,708

 
364

Total available-for-sale securities
 
$
366,445

 
$
5,915

 
$
62,480

 
$
2,157

 
$
428,925

 
$
8,072

 
558



 
 
At December 31, 2017
 
 
Less than 12 months
 
12 months or longer
 
Total
(dollars in thousands)
 
Fair
value
 
Unrealized
losses
 
Fair
value
 
Unrealized
losses
 
Fair
value
 
Unrealized
losses
 
No. of
holdings
Available-for-sale securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. treasury
 
$
10,237

 
$
110

 
$
1,497

 
$
29

 
$
11,734

 
$
139

 
4

States & political subdivisions
 
52,553

 
288

 
14,361

 
332

 
66,914

 
620

 
33

Corporate debt securities
 
171,154

 
1,585

 
31,113

 
339

 
202,267

 
1,924

 
331

Residential mortgage-backed securities
 
4,156

 
29

 
7,064

 
95

 
11,220

 
124

 
11

Commercial mortgage-backed securities
 
10,836

 
85

 
11,984

 
612

 
22,820

 
697

 
19

Collateralized debt obligations
 
21,598

 
41

 
0

 
0

 
21,598

 
41

 
12

Other debt securities
 
1,499

 
0

 
0

 
0

 
1,499

 
0

 
1

Total fixed maturities
 
272,033

 
2,138

 
66,019

 
1,407

 
338,052

 
3,545

 
411

Nonredeemable preferred stock - financial services sector
 
9,644

 
25

 
0

 
0

 
9,644

 
25

 
1

Nonredeemable preferred stock - utilities sector
 
1,093

 
75

 
0

 
0

 
1,093

 
75

 
5

Total available-for-sale securities
 
$
282,770

 
$
2,238

 
$
66,019

 
$
1,407

 
$
348,789

 
$
3,645

 
417

Quality breakdown of fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Investment grade
 
$
214,586

 
$
1,064

 
$
62,193

 
$
985

 
$
276,779

 
$
2,049

 
158

Non-investment grade
 
57,447

 
1,074

 
3,826

 
422

 
61,273

 
1,496

 
253

Total fixed maturities
 
$
272,033

 
$
2,138

 
$
66,019

 
$
1,407

 
$
338,052

 
$
3,545

 
411

 
 
The above securities have been evaluated and determined to be temporary impairments for which we expect to recover our entire principal plus interest.  The primary components of this analysis include a general review of market conditions and financial performance of the issuer along with the extent and duration at which fair value is less than cost.  Any securities that we intend to sell or will more likely than not be required to sell before recovery are included in other-than-temporary impairments, which are recognized in earnings.


18


Net investment income
Interest and dividend income are recognized as earned and recorded to net investment income. Investment income, net of expenses, was generated from the following portfolios:
 
 
Three months ended March 31,
(in thousands)
 
2018
 
2017
Fixed maturities (1)
 
$
6,110

 
$
5,904

Equity securities
 
142

 
32

Cash equivalents and other
 
1,008

 
521

Total investment income
 
7,260

 
6,457

Less: investment expenses
 
440

 
476

Investment income, net of expenses
 
$
6,820

 
$
5,981


    (1) Includes interest earned on note receivable from Erie Family Life Insurance Company ("EFL") of $0.4 million in 2018 and 2017.
 

Realized investment gains (losses)
Realized gains and losses on sales of securities are recognized in income based upon the specific identification method. Realized gains (losses) on investments were as follows:
 
 
Three months ended March 31,
(in thousands)
 
2018
 
2017
Available-for-sale securities:
 
 

 
 

Gross realized gains
 
$
340

 
$
580

Gross realized losses
 
(685
)
 
(158
)
Net realized (losses) gains on available-for-sale securities
 
(345
)
 
422

Equity securities
 
(120
)
 

Miscellaneous
 
0

 
94

Net realized investment (losses) gains
 
$
(465
)
 
$
516


 
The portion of net unrealized losses recognized during the reporting period, related to equity securities still held at the reporting date, is calculated as follows:
 
 
Three months ended March 31,
(in thousands)
 
2018
 
2017
Equity securities: (1)
 
 
 
 
Total net realized losses
 
$
(120
)
 
$

Less: net losses realized on securities sold
 
(34
)
 

Net unrealized losses recognized during the period on securities held at reporting date
 
$
(86
)
 
$

 
(1) With the adoption of ASU 2016-01, effective January 1, 2018, changes in unrealized gains and losses on equity securities are included in net realized investment gains (losses) in the Statement of Operations. The adoption of this guidance resulted in a reclassification of net unrealized losses of $0.1 million from accumulated other comprehensive loss to retained earnings at January 1, 2018.


There were no other-than-temporary impairments on available-for-sale securities recognized in earnings during the quarter ended March 31, 2018. Other-than-temporary impairments on available-for-sale securities recognized in earnings were $0.1 million for the quarter ended March 31, 2017. We have the intent to sell all credit-impaired available-for-sale debt securities; therefore, the entire amount of the impairment charges were included in earnings and no non-credit impairments were recognized in other comprehensive income. 



19


Limited partnerships
The majority of our limited partnership holdings are considered investment companies where the general partners record assets at fair value. These limited partnerships are recorded using the equity method of accounting and are generally reported on a one-quarter lag; therefore, our year-to-date limited partnership results through March 31, 2018 are comprised of partnership financial results for the fourth quarter of 2017.  Given the lag in reporting, our limited partnership results do not reflect the market conditions of the first quarter of 2018. We also own some real estate limited partnerships that do not meet the criteria of an investment company. These partnerships prepare audited financial statements on a cost basis. We have elected to report these limited partnerships under the fair value option, which is based on the NAV from our partner's capital statement reflecting the general partner's estimate of fair value for the fund's underlying assets. Fair value provides consistency in the evaluation and financial reporting for these limited partnerships and limited partnerships accounted for under the equity method. Cash contributions made to and distributions received from the partnerships are recorded in the period in which the transaction occurs.

Amounts included in equity in (losses) earnings of limited partnerships by method of accounting are included below:
 
 
 
Three months ended March 31,
(in thousands)
 
2018
 
2017
Equity in earnings of limited partnerships accounted for under the equity method
 
$
195

 
$
250

Change in fair value of limited partnerships accounted for under the fair value option
 
(387
)
 
(37
)
Equity in (losses) earnings of limited partnerships
 
$
(192
)
 
$
213



The following table summarizes limited partnership investments by sector:

(in thousands)
 
At March 31, 2018
 
At December 31, 2017
Private equity
 
$
31,705

 
$
31,663

Mezzanine debt
 
3,288

 
3,516

Real estate
 
4,692

 
5,127

Real estate - fair value option
 
4,429

 
4,816

Total limited partnership investments
 
$
44,114

 
$
45,122



See also Note 13, "Commitments and Contingencies" for investment commitments related to limited partnerships.
 
 
 
 
 
 
 

 

20


Note 7.  Borrowing Arrangements
 
Bank line of credit
As of March 31, 2018, we have access to a $100 million bank revolving line of credit with a $25 million letter of credit sublimit that expires on November 3, 2020. As of March 31, 2018, a total of $99.1 million remains available under the facility due to $0.9 million outstanding letters of credit, which reduce the availability for letters of credit to $24.1 million.  We had no borrowings outstanding on our line of credit as of March 31, 2018.  Bonds with a fair value of $108.6 million were pledged as collateral on the line at March 31, 2018. The securities pledged as collateral have no trading restrictions and are reported as available-for-sale securities in the Statements of Financial Position as of March 31, 2018. The banks require compliance with certain covenants, which include leverage ratios and debt restrictions, for our line of credit.  We are in compliance with all covenants at March 31, 2018.

Term loan credit facility
In 2016, we entered into a credit agreement for a $100 million senior secured draw term loan credit facility ("Credit Facility") for the acquisition of real property and construction of an office building that will serve as part of our principal headquarters. Under the agreement, $25 million will be drawn on December 1, 2016, June 1, 2017, December 1, 2017, and June 1, 2018 ("Draw Period"). During the Draw Period, we will make monthly interest only payments under the Credit Facility and thereafter the Credit Facility converts to a fully-amortized term loan with monthly payments of principal and interest over a period of 28 years. Borrowings under the Credit Facility will bear interest at a fixed rate of 4.35%. In addition, we are required to pay a quarterly commitment fee of 0.08% on the unused portion of the Credit Facility during the Draw Period. Total draws against the facility are $75 million as of March 31, 2018. Bonds with a fair value of $108.8 million were pledged as collateral for the facility and are reported as available-for-sale debt securities in the Statements of Financial Position as of March 31, 2018. The bank requires compliance with certain covenants, which include leverage ratios, debt restrictions and minimum net worth, for our Credit Facility. We are in compliance with all covenants at March 31, 2018.
 
Amounts drawn from the Credit Facility are reported at carrying value on our Statements of Financial Position, net of unamortized loan origination and commitment fees. The estimated fair value of this borrowing at March 31, 2018 was $70.4 million. The estimated fair value was determined using estimates based upon interest rates and credit spreads and are classified as Level 3 in the fair value hierarchy as of March 31, 2018.
 
The scheduled maturity of the $100 million Credit Facility begins on January 1, 2019 with annual principal payments of $1.9 million in 2019, $2.0 million in 2020, $2.0 million in 2021, $2.1 million in 2022, $2.2 million in 2023 and $89.8 million thereafter.



21


Note 8.  Postretirement Benefits
 
Pension plans
Our pension plans consist of a noncontributory defined benefit pension plan covering substantially all employees and an unfunded supplemental employee retirement plan for certain members of executive and senior management. Although we are the sponsor of these postretirement plans and record the funded status of these plans, the Exchange and its subsidiaries reimburse us for approximately 59% of the annual benefit expense of these plans, which represents pension benefits for employees performing administrative services and their allocated share of costs for employees in departments that support the administrative functions.
 
An accelerated contribution of $40 million was made to the defined benefit pension plan in the first quarter of 2018, and an additional $40 million contribution was made in April 2018.

Prior to 2003, the employee pension plan purchased annuities from EFL for certain plan participants that were receiving benefit payments under the pension plan. These are nonparticipating annuity contracts under which EFL has unconditionally contracted to provide specified benefits to beneficiaries; however, the pension plan remains the primary obligor to the beneficiaries. A contingent liability of $19.0 million at March 31, 2018 exists in the event EFL does not honor the annuity contracts.
 
The cost of our pension plans are as follows:
 
 
Three months ended March 31,
(in thousands)
 
2018
 
2017
Service cost for benefits earned
 
$
9,513

 
$
7,777

Interest cost on benefits obligation
 
8,846

 
8,569

Expected return on plan assets
 
(12,815
)
 
(10,317
)
Prior service cost amortization
 
338

 
218

Net actuarial loss amortization
 
3,202

 
2,325

Pension plan cost (1)
 
$
9,084

 
$
8,572

 
(1)
The components of pension plan costs other than the service cost component are included in the line item "Other income (expense)" in the Statements of Operations after reimbursements from the Exchange and its subsidiaries.


Note 9.  Income Taxes

The effective tax rate may differ from the statutory federal tax rate primarily due to permanent differences for tax exempt interest income.
 
Income tax amounts are estimates based on our initial analysis and current interpretation of the Tax Cuts and Jobs Act enacted in 2017. Given the complexity of the legislation, anticipated guidance from the U.S. Treasury, and the potential for additional guidance from the Securities and Exchange Commission or the FASB, these estimates may be adjusted during 2018.



22


Note 10.  Capital Stock
 
Class A and B common stock
Holders of Class B shares may, at their option, convert their shares into Class A shares at the rate of 2,400 Class A shares per Class B share.  There were no shares of Class B common stock converted into Class A common stock during the three months ended March 31, 2018 and the year ended December 31, 2017. There is no provision for conversion of Class A shares to Class B shares, and Class B shares surrendered for conversion cannot be reissued.
 
Stock repurchases
In 2011, our Board of Directors approved a continuation of the current stock repurchase program of $150 million, with no time limitation.  There were no shares repurchased under this program during the three months ended March 31, 2018 and the year ended December 31, 2017. We had approximately $17.8 million of repurchase authority remaining under this program at March 31, 2018.
 
During the three months ended March 31, 2018, we purchased 17,291 shares of our outstanding Class A nonvoting common stock outside of our publicly announced share repurchase program at a total cost of $2.1 million. Of this amount, we purchased 3,250 shares for $0.4 million, or $119.83 per share, for stock-based awards in conjunction with our equity compensation plan. We purchased 2,284 shares for $0.3 million, or $114.87 per share, to fund the rabbi trust for the outside director deferred stock compensation plan. The remaining 11,757 shares were purchased at a total cost of $1.4 million, or $119.17 per share, to fund the rabbi trust for the incentive compensation deferral plan. The shares were transferred to the rabbi trust in March 2018.

During the year ended December 31, 2017, we purchased 60,332 shares of our outstanding Class A nonvoting common stock outside of our publicly announced share repurchase program at a total cost of $7.3 million. Of this amount, we purchased 3,785 shares for $0.4 million, or $111.55 per share, for stock-based awards in conjunction with our equity compensation plan. We purchased 9,663 shares for $1.2 million, or $121.85 per share, to fund the rabbi trust for the outside director deferred stock compensation plan. The remaining 46,884 shares were purchased at a total cost of $5.7 million, or $122.40 per share, for the vesting of stock-based awards in conjunction with our long-term incentive plan. These shares were delivered in 2017.


23


Note 11.  Accumulated Other Comprehensive Income (Loss)
 
Changes in accumulated other comprehensive income ("AOCI") (loss) by component, including amounts reclassified to other comprehensive income ("OCI") (loss) and the related line item in the Statements of Operations where net income is presented, are as follows:
 
 
Three months ended
 
Three months ended
 
 
March 31, 2018
 
March 31, 2017
(in thousands)
 
Before Tax
Income Tax (1)
Net
 
Before Tax
Income Tax (1)
Net
Investment securities:
 
 
 
 
 
 
 
 
AOCI, beginning of period
 
$
3,410

$
716

$
2,694

 
$
3,954

$
1,384

$
2,570

OCI before reclassifications
 
(7,130
)
(1,497
)
(5,633
)
 
2,640

924

1,716

Realized investment losses (gains)
 
345

72

273

 
(422
)
(148
)
(274
)
Impairment losses
 
0

0

0

 
121

42

79

Cumulative effect of adopting ASU 2016-01 (2)
 
(85
)
(18
)
(67
)
 



OCI (loss)
 
(6,870
)
(1,443
)
(5,427
)
 
2,339

818

1,521

AOCI, end of period
 
$
(3,460
)
$
(727
)
$
(2,733
)
 
$
6,293

$
2,202

$
4,091

 
 
 
 
 
 
 
 
 
Pension and other postretirement plans: (3)
 
 
 
 
 
 
 
 
AOCI (loss), beginning of period
 
$
(200,954
)
$
(42,201
)
$
(158,753
)
 
$
(190,695
)
$
(66,744
)
$
(123,951
)
AOCI (loss), end of period
 
$
(200,954
)
$
(42,201
)
$
(158,753
)
 
$
(190,695
)
$
(66,744
)
$
(123,951
)
 
 
 
 
 
 
 
 
 
Total
 
 
 
 
 
 
 
 
AOCI (loss), beginning of period
 
$
(197,544
)
$
(41,485
)
$
(156,059
)
 
$
(186,741
)
$
(65,360
)
$
(121,381
)
Investment securities
 
(6,870
)
(1,443
)
(5,427
)
 
2,339

818

1,521

Pension and other postretirement plans
 
0

0

0

 
0

0

0

OCI (loss)
 
(6,870
)
(1,443
)
(5,427
)
 
2,339

818

1,521

AOCI (loss), end of period
 
$
(204,414
)
$
(42,928
)
$
(161,486
)
 
$
(184,402
)
$
(64,542
)
$
(119,860
)
 
(1)
Deferred taxes were recognized at the corporate rate of 21% and 35% for the three months ended March 31, 2018 and 2017, respectively.
(2)
ASU 2016-01 required a reclassification of unrealized losses of equity securities from AOCI to retained earnings at January 1, 2018. See Note 2, "Significant Accounting Policies".
(3)
There are no comprehensive income items or amounts reclassified out of accumulated other comprehensive loss related to postretirement plan items during interim periods.

 
 
 
 
 
 
 
 
 
Note 12. Concentrations of Credit Risk

Financial instruments could potentially expose us to concentrations of credit risk, including unsecured receivables from the Exchange. A large majority of our revenue and receivables are from the Exchange and its subsidiaries. See also Note 1, "Nature of Operations". Management fee amounts and other reimbursements due from the Exchange and its subsidiaries were $415.3 million and $418.3 million at March 31, 2018 and December 31, 2017, respectively.



24


Note 13.  Commitments and Contingencies
 
We have contractual commitments to invest up to $14.3 million related to our limited partnership investments at March 31, 2018.  These commitments are split among private equity securities of $5.8 million, mezzanine debt securities of $8.2 million, and real estate activities of $0.3 million.  These commitments will be funded as required by the limited partnership agreements.

We are involved in litigation arising in the ordinary course of conducting business.  In accordance with current accounting standards for loss contingencies and based upon information currently known to us, we establish reserves for litigation when it is probable that a loss associated with a claim or proceeding has been incurred and the amount of the loss or range of loss can be reasonably estimated.  When no amount within the range of loss is a better estimate than any other amount, we accrue the minimum amount of the estimable loss.  To the extent that such litigation against us may have an exposure to a loss in excess of the amount we have accrued, we believe that such excess would not be material to our financial condition, results of operations, or cash flows.  Legal fees are expensed as incurred.  We believe that our accruals for legal proceedings are appropriate and, individually and in the aggregate, are not expected to be material to our financial condition, results of operations, or cash flows.

We review all litigation on an ongoing basis when making accrual and disclosure decisions.  For certain legal proceedings, we cannot reasonably estimate losses or a range of loss, if any, particularly for proceedings that are in their early stages of development or where the plaintiffs seek indeterminate damages.  Various factors, including, but not limited to, the outcome of potentially lengthy discovery and the resolution of important factual questions, may need to be determined before probability can be established or before a loss or range of loss can be reasonably estimated.  If the loss contingency in question is not both probable and reasonably estimable, we do not establish an accrual and the matter will continue to be monitored for any developments that would make the loss contingency both probable and reasonably estimable.  In the event that a legal proceeding results in a substantial judgment against, or settlement by, us, there can be no assurance that any resulting liability or financial commitment would not have a material adverse effect on the financial condition, results of operations, or cash flows.


Note 14.  Subsequent Events
 
No items were identified in this period subsequent to the financial statement date that required adjustment or additional disclosure.



25


ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
The following discussion of financial condition and results of operations highlights significant factors influencing Erie Indemnity Company ("Indemnity", "we", "us", "our").  This discussion should be read in conjunction with the historical financial statements and the related notes thereto included in Part I, Item 1. "Financial Statements" of this Quarterly Report on Form 10-Q, and with Item 7. "Management’s Discussion and Analysis of Financial Condition and Results of Operations" for the year ended December 31, 2017, as contained in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on February 22, 2018.
 
 
INDEX
 

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION