ERIE INDEMNITY CO - FORM 10-Q - May 1, 2017

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EX-32 - EXHIBIT 32 - ERIE INDEMNITY COex-3203312017.htm
EX-31.2 - EXHIBIT 31.2 - ERIE INDEMNITY COex-31203312017.htm
EX-31.1 - EXHIBIT 31.1 - ERIE INDEMNITY COex-31103312017.htm
EX-10.1 - EXHIBIT 10.1 - ERIE INDEMNITY COex-10103312017.htm

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, 2017
 
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 14, 2017.
 
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 14, 2017.


 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

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,
 
 
2017
 
2016
Operating revenue
 
 
 
 
Management fee revenue, net
 
$
392,058

 
$
367,458

Service agreement revenue
 
7,258

 
7,270

Total operating revenue
 
399,316

 
374,728

 
 
 
 
 
Operating expenses
 
 
 
 
Commissions
 
220,478

 
208,714

Salaries and employee benefits
 
59,740

 
53,289

All other operating expenses
 
52,564

 
45,060

Total operating expenses
 
332,782

 
307,063

Net revenue from operations
 
66,534

 
67,665

 
 
 
 
 
Investment income
 
 
 
 
Net investment income
 
5,978

 
4,662

Net realized investment gains (losses)
 
516

 
(1,088
)
Net impairment losses recognized in earnings
 
(121
)
 
(345
)
Equity in earnings (losses) of limited partnerships
 
213

 
(670
)
Total investment income
 
6,586

 
2,559

Interest expense, net
 
166

 
—

Income before income taxes
 
72,954

 
70,224

Income tax expense
 
25,078

 
24,329

Net income
 
$
47,876

 
$
45,895

 
 
 
 
 
 
 
 
 
 
Earnings Per Share
 
 
 
 
Net income per share
 
 
 
 
Class A common stock – basic
 
$
1.03

 
$
0.99

Class A common stock – diluted
 
$
0.91

 
$
0.87

Class B common stock – basic and diluted
 
$
154

 
$
148

 
 
 
 
 
Weighted average shares outstanding – Basic
 
 
 
 
Class A common stock
 
46,188,522

 
46,189,068

Class B common stock
 
2,542

 
2,542

 
 
 
 
 
Weighted average shares outstanding – Diluted
 
 
 
 
Class A common stock
 
52,408,560

 
52,523,927

Class B common stock
 
2,542

 
2,542

 
 
 
 
 
Dividends declared per share
 
 
 
 
Class A common stock
 
$
0.7825

 
$
0.7300

Class B common stock
 
$
117.3750

 
$
109.5000

 
 
See accompanying notes to Financial Statements. See Note 10, "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,
 
 
2017
 
2016
Net income
 
$
47,876

 
$
45,895

 
 
 
 
 
Other comprehensive income, net of tax
 
 
 
 
Change in unrealized holding gains on available-for-sale securities
 
1,521

 
3,465

 
 
 
 
 
Comprehensive income
 
$
49,397

 
$
49,360

 
See accompanying notes to Financial Statements. See Note 10, "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,
 
 
2017
 
2016
Assets
 
(Unaudited)
 
 
Current assets:
 
 
 
 
Cash and cash equivalents
 
$
110,418

 
$
189,072

Available-for-sale securities
 
77,412

 
56,138

Receivables from Erie Insurance Exchange and affiliates
 
392,319

 
378,540

Prepaid expenses and other current assets
 
39,065

 
30,169

Federal income taxes recoverable
 
0

 
5,260

Accrued investment income
 
6,504

 
6,337

Total current assets
 
625,718

 
665,516

 
 
 
 
 
Available-for-sale securities
 
642,457

 
657,153

Limited partnership investments
 
54,457

 
58,159

Fixed assets, net
 
68,685

 
69,142

Deferred income taxes, net
 
52,495

 
53,889

Note receivable from Erie Family Life Insurance Company
 
25,000

 
25,000

Other assets
 
21,224

 
20,096

Total assets
 
$
1,490,036

 
$
1,548,955

 
 
 
 
 
Liabilities and shareholders' equity
 
 
 
 
Current liabilities:
 
 
 
 
Commissions payable
 
$
219,256

 
$
210,559

Agent bonuses
 
32,882

 
114,772

Accounts payable and accrued liabilities
 
81,551

 
88,153

Dividends payable
 
36,441

 
36,441

Deferred executive compensation
 
14,613

 
19,675

Federal income taxes payable
 
19,478

 
0

Total current liabilities
 
404,221

 
469,600

 
 
 
 
 
Defined benefit pension plans
 
211,415

 
221,827

Employee benefit obligations
 
605

 
756

Deferred executive compensation
 
16,212

 
13,233

Long-term borrowings
 
24,753

 
24,766

Other long-term liabilities
 
2,972

 
1,863

Total liabilities
 
660,178

 
732,045

 
 
 
 
 
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
 
16,292

 
16,300

Accumulated other comprehensive loss
 
(119,860
)
 
(121,381
)
Retained earnings
 
2,077,346

 
2,065,911

Total contributed capital and retained earnings
 
1,975,948

 
1,963,000

Treasury stock, at cost; 22,110,132 shares held
 
(1,156,162
)
 
(1,155,846
)
Deferred compensation
 
10,072

 
9,756

Total shareholders’ equity
 
829,858

 
816,910

Total liabilities and shareholders’ equity
 
$
1,490,036

 
$
1,548,955

 
See accompanying notes to Financial Statements. 

5

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

 
 
Three months ended
 
 
March 31,
 
 
2017
 
2016
Cash flows from operating activities
 
 
 
 
Management fee received
 
$
389,346

 
$
363,848

Service agreement fee received
 
7,258

 
7,270

Net investment income received
 
7,553

 
6,182

Limited partnership distributions
 
643

 
1,127

Decrease in reimbursements collected from affiliates
 
(11,066
)
 
(785
)
Commissions paid to agents
 
(182,652
)
 
(172,625
)
Agents bonuses paid
 
(111,275
)
 
(103,933
)
Salaries and wages paid
 
(47,442
)
 
(45,732
)
Pension contribution and employee benefits paid
 
(26,557
)
 
(24,636
)
General operating expenses paid
 
(61,000
)
 
(52,220
)
Income taxes recovered (paid)
 
234

 
(258
)
Interest paid
 
(164
)
 
—

Net cash used in operating activities
 
(35,122
)
 
(21,762
)
 
 
 
 
 
Cash flows from investing activities
 
 
 
 
Purchase of investments:
 
 
 
 
Available-for-sale securities
 
(65,521
)
 
(67,557
)
Limited partnerships
 
(111
)
 
(103
)
Proceeds from investments:
 
 
 
 
Available-for-sale securities sales
 
16,633

 
12,871

Available-for-sale securities maturities/calls
 
43,460

 
33,636

Limited partnerships
 
3,396

 
1,792

Net purchase of fixed assets
 
(3,551
)
 
(3,496
)
Net (distributions) collections on agent loans
 
(1,387
)
 
1,008

Net cash used in investing activities
 
(7,081
)
 
(21,849
)
 
 
 
 
 
Cash flows from financing activities
 
 
 
 
Dividends paid to shareholders
 
(36,441
)
 
(33,996
)
Net costs from long-term borrowings
 
(10
)
 
—

Net cash used in financing activities
 
(36,451
)
 
(33,996
)
 
 
 
 
 
Net decrease in cash and cash equivalents
 
(78,654
)
 
(77,607
)
Cash and cash equivalents, beginning of period
 
189,072

 
182,889

Cash and cash equivalents, end of period
 
$
110,418

 
$
105,282

  
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 certain services for the Exchange relating to the sales, underwriting, and issuance of policies on behalf of the Exchange.  This 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 and to manage the affairs of the Exchange.  Pursuant to the subscriber’s agreement and for its services as attorney-in-fact, we earn a management fee calculated as a percentage of the direct and assumed premiums written by the Exchange.

The 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.

By virtue of its legal structure as a reciprocal insurer, the Exchange does not have the ability to enter into contractual relationships and therefore Indemnity serves as the attorney-in-fact on behalf of the Exchange for all claims handling services, investment management services, and certain other common overhead and service department functions in accordance with the subscriber’s agreement. The amounts Indemnity incurs on behalf of the Exchange in this capacity are reimbursed to Indemnity from the Exchange at cost.

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" contained within this report.



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, 2017 are not necessarily indicative of the results that may be expected for the year ending December 31, 2017. For further information, refer to the financial statements and footnotes included in our Form 10-K for the year ended December 31, 2016 as filed with the Securities and Exchange Commission on February 23, 2017.

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
In January 2017, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2017-03, "Accounting Changes and Error Corrections and Investments-Equity Method and Joint Ventures". ASU 2017-03 requires registrants to determine the appropriate financial statement disclosure about the potential material effects of recently issued ASUs on the financial statements when adopted. If the impact cannot be reasonably estimated, a statement to that effect should be made and consideration given to additional qualitative disclosures to assist the reader in assessing the significance of the impact to the financial statements. Qualitative disclosures should include a description of the effect of the accounting policies that are expected to apply and a comparison to current accounting policies, as well as the status of implementation and significant implementation matters yet to be addressed. This ASU also requires consistent application of the proportional amortization method to all investments in qualified affordable housing projects, if that accounting treatment is elected. This guidance was effective upon issuance. We have conformed our disclosures of recently issued but not yet adopted ASUs to be in accordance with this guidance. There is no impact on our financial statements related to the investments in qualified affordable housing projects, as these investments are immaterial and we have not elected to apply the proportional amortization method.

In August 2016, the FASB issued ASU 2016-15, "Statement of Cash Flows", which provides guidance on how certain cash receipts and cash payments are presented and classified to reduce diversity in practice. ASU 2016-15 is effective for interim and annual reporting periods beginning after December 31, 2017. Early adoption is permitted, including adoption in an interim period. There were no changes to the presentation in our Statements of Cash Flows resulting from this guidance.

Recently issued accounting standards
In March 2017, the FASB issued ASU 2017-07, "Compensation-Retirement Benefits", which requires the service cost component of net benefit costs 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. This amendment also allows only the service cost component to be eligible for capitalization when applicable. The guidance is effective for interim and annual periods beginning after December 15, 2017. We do not expect a material impact on our financial statements as although the presentation of the costs within the Statements of Operations will change, net income will not be affected.

In March 2017, the FASB issued ASU 2017-08, "Receivables-Nonrefundable Fees and Other Costs", which shortens the amortization period for certain purchased callable debt securities held at a premium, from maturity date to the earliest call date. ASU 2017-08 is effective for interim and annual reporting periods beginning after December 31, 2018. The guidance should be applied using a modified retrospective basis through a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. Early adoption is permitted, including adoption in an interim period. We do not expect the adoption of this guidance to have a material impact on our financial statements.

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 are currently evaluating the impact of this guidance on our invested assets. None of our current investments are measured at amortized cost, which are the investments

8

that require the use of a new expected loss model. Our available-for-sale debt securities will continue to be evaluated for credit losses but this will be reflected as an allowance for credit losses rather than a reduction of the carrying value of the asset. We will begin evaluating the impact of recording reversals of credit losses in current period net income, which is prohibited under current guidance, in the second quarter of 2017. We are continuing to evaluate the impact of this guidance on any other financial instruments and disclosures.

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. In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. Early adoption is permitted. We expect to adopt ASU 2016-02 as of January 1, 2019 using the modified retrospective method. Under existing guidance, we recognize lease expense as a component of operating expenses on the Statements of Operations. We are in the process of evaluating our existing lease contracts to determine the impact to our financial statements and disclosures.

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.  The fair value of our equity securities at March 31, 2017 is approximately $6 million. Recognizing the change in fair value of our equity securities through net income, instead of accumulated other comprehensive income as required under current guidance, would have resulted in $0.1 million reduction in fair value being recognized in the Statement of Operations for the quarter ended March 31, 2017.

In May 2014, the FASB issued ASU 2014-09, "Revenue from Contracts with Customers". ASU 2014-09 requires an entity to recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance is effective for fiscal years beginning after December 15, 2017, including interim periods within that reporting period with early application permitted beginning in the first interim period in 2017. We expect to adopt the ASU 2014-09 as of January 1, 2018 under the modified retrospective method where the cumulative effect is recognized at the date of initial application. Our evaluation of ASU 2014-09 is ongoing and not complete. The FASB has issued, and may issue in the future, interpretative guidance which may cause our evaluation to change. Based on the current guidance, we performed an analysis in accordance with the steps identified in the guidance around the recognition, measurement, and presentation of our two operating revenue streams; management fee revenue and service fee revenue. As a result of this analysis, we concluded that adoption of this guidance will not have a material impact on our revenue recognition patterns or our financial statements. We plan to begin evaluating the new disclosure requirements in the second quarter of 2017.



9

Note 3.  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 9, "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:
 
(dollars in thousands, except per share data)
 
Three months ended March 31,
 
 
2017
 
2016
 
 
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
 
$
47,484

 
46,188,522

 
$
1.03

 
$
45,520

 
46,189,068

 
$
0.99

Dilutive effect of stock-based awards
 
0

 
119,238

 
—

 
0

 
234,059

 
—

Assumed conversion of Class B shares
 
392

 
6,100,800

 
—

 
375

 
6,100,800

 
—

Class A – Diluted EPS:
 
 
 
 
 
 
 
 
 
 
 
 
Income available to Class A stockholders on Class A equivalent shares
 
$
47,876

 
52,408,560

 
$
0.91

 
$
45,895

 
52,523,927

 
$
0.87

Class B – Basic and diluted EPS:
 
 
 
 
 
 
 
 
 
 
 
 
Income available to Class B stockholders
 
$
392

 
2,542

 
$
154

 
$
375

 
2,542

 
$
148

 
 
 
 
 
 
 
 
 
 
 
 
 

10

Note 4. Fair Value
 
Our available-for-sale and trading 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 and trading 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 the majority of our prices are obtained from third party sources, we also perform an internal pricing review for securities with low trading volumes under 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 data, and transaction volumes and believe that their prices adequately consider market activity in determining fair value.  Our review process continues to evolve based upon accounting guidance and requirements.
 
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.
 
For certain securities in an illiquid market, there may be no prices available from a pricing service and no comparable market quotes available.  In these situations, we value the security using an internally-developed, risk-adjusted discounted cash flow model.


11

The following tables present our fair value measurements on a recurring basis by asset class and level of input:
 
 
 
At March 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
 
$
5,038

 
$
0

 
$
5,038

 
$
0

Government sponsored entities
 
2,004

 
0

 
2,004

 
0

States & political subdivisions
 
255,128

 
0

 
255,128

 
0

Corporate debt securities
 
326,169

 
0

 
316,366

 
9,803

Residential mortgage-backed securities
 
14,799

 
0

 
14,799

 
0

Commercial mortgage-backed securities
 
37,905

 
0

 
37,905

 
0

Collateralized debt obligations
 
70,832

 
0

 
70,832

 
0

Other debt securities
 
2,002

 
0

 
2,002

 
0

Total fixed maturities
 
713,877

 
0

 
704,074

 
9,803

Common stock
 
5,992

 
5,992

 
0

 
0

Total available-for-sale securities
 
719,869

 
5,992

 
704,074

 
9,803

Other investments (1)
 
4,376

 
—

 
—

 
—

Total
 
$
724,245

 
$
5,992

 
$
704,074

 
$
9,803


 
 
At December 31, 2016
 
 
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
 
$
5,031

 
$
0

 
$
5,031

 
$
0

Government sponsored entities
 
2,026

 
0

 
2,026

 
0

States & political subdivisions
 
253,132

 
0

 
253,132

 
0

Corporate debt securities
 
322,948

 
0

 
313,596

 
9,352

Residential mortgage-backed securities
 
16,102

 
0

 
16,102

 
0

Commercial mortgage-backed securities
 
36,849

 
0

 
36,849

 
0

Collateralized debt obligations
 
69,253

 
0

 
69,253

 
0

Other debt securities
 
2,000

 
0

 
2,000

 
0

Total fixed maturities
 
707,341

 
0

 
697,989

 
9,352

Common stock
 
5,950

 
5,950

 
0

 
0

Total available-for-sale securities
 
713,291

 
5,950

 
697,989

 
9,352

Other investments (1)
 
4,412

 
—

 
—

 
—

Total
 
$
717,703

 
$
5,950

 
$
697,989

 
$
9,352


(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, 2017 and December 31, 2016. During the three months ended March 31, 2017, no contributions were made and no distributions were received from these investments. During the year ended December 31, 2016, no contributions were made and distributions totaling $0.9 million were received from these investments. There were no unfunded commitments related to the investments as of March 31, 2017, and $0.3 million as of December 31, 2016.


12

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
in and (out) of
Level 3
 
Ending balance at March 31, 2017
Available-for-sale securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
9,352

 
$
(50
)
 
$
(25
)
 
$
1,871

 
$
(1,849
)
 
$
504

 
$
9,803

Total fixed maturities
 
9,352

 
(50
)
 
(25
)
 
1,871

 
(1,849
)
 
504

 
9,803

Total available-for-sale securities
 
9,352

 
(50
)
 
(25
)
 
1,871

 
(1,849
)
 
504

 
9,803

Total Level 3 assets
 
$
9,352

 
$
(50
)
 
$
(25
)
 
$
1,871

 
$
(1,849
)
 
$
504

 
$
9,803


(1)
These amounts are reported in the Statement of Operations as net investment income and net realized investment gains (losses) for the three months ended March 31, 2017 on Level 3 securities.
 

We review the fair value hierarchy classifications each reporting period.  Transfers between hierarchy levels may occur due to changes in the available market observable inputs.  Transfers in and out of level classifications are reported as having occurred at the beginning of the quarter in which the transfers occurred.

There were no transfers between Level 1 and Level 2 for the three months ended March 31, 2017. Level 2 to Level 3 transfers totaled $2.2 million for nine fixed maturity holdings due to the use of unobservable market data to determine the fair value at March 31, 2017. Level 3 to Level 2 transfers totaled $1.7 million for eight fixed maturity holdings due to the use of observable market data to determine the fair value at March 31, 2017.

 
Level 3 Assets – Year-to-Date Change:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(in thousands)
 
 
Beginning balance at December 31, 2015
 
Included in
earnings (1)
 
Included
in other
comprehensive
income
 
Purchases
 
Sales
 
Transfers
in and (out) of
Level 3
 
Ending balance at March 31, 2016
Available-for-sale securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
69

 
$
15

 
$
27

 
$
3,539

 
$
(55
)
 
$
1,226

 
$
4,821

Collateralized debt obligations
 
8,577

 
4

 
(12
)
 
3,522

 
(54
)
 
0

 
12,037

Total fixed maturities
 
8,646

 
19

 
15

 
7,061

 
(109
)
 
1,226

 
16,858

Total available-for-sale securities
 
8,646

 
19

 
15

 
7,061

 
(109
)
 
1,226

 
16,858

Total Level 3 assets
 
$
8,646

 
$
19

 
$
15

 
$
7,061

 
$
(109
)
 
$
1,226

 
$
16,858


(1)
These amounts are reported in the Statement of Operations as net investment income and net realized investment gains (losses) for the three months ended March 31, 2016 on Level 3 securities.
 

There were no transfers between Level 1 and Level 2 for the three months ended March 31, 2016. Level 2 to Level 3 transfers totaled $1.3 million for nine fixed maturity holdings due to the use of unobservable market data to determine fair value at March 31, 2016. Level 3 to Level 2 transfers totaled $0.1 million for one fixed maturity holding due to the use of observable market data to determine the fair value at March 31, 2016.

 
 




13

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 brokers quotes totaled $9.8 million at March 31, 2017. The unobservable inputs are not reasonably available to us.

The following table presents our fair value measurements on a recurring basis by pricing source:
 
(in thousands)
 
At March 31, 2017
 
 
Total
 
Level 1
 
Level 2
 
Level 3
Fixed maturities:
 
 
 
 
 
 
 
 
Priced via pricing services
 
$
712,319

 
$
0

 
$
702,516

 
$
9,803

Priced via market comparables/broker quotes
 
1,558

 
0

 
1,558

 
0

Total fixed maturities
 
713,877

 
0

 
704,074

 
9,803

Common stock:
 
 
 
 
 
 
 
 
Priced via pricing services
 
5,992

 
5,992

 
0

 
0

Total common stock
 
5,992

 
5,992

 
0

 
0

Other investments:
 
 
 
 
 
 
 
 
Priced via unobservable inputs (1)
 
4,376

 
—

 
—

 
—

Total other investments
 
4,376

 
—

 
—

 
—

Total
 
$
724,245

 
$
5,992

 
$
704,074

 
$
9,803

 


(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 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, 2017.



14

Note 5.  Investments
 
Available-for-sale securities
The following table summarizes the cost and fair value of our available-for-sale securities:
 
 
 
At March 31, 2017
 (in thousands)
 
Amortized
cost
 
Gross unrealized gains
 
Gross unrealized losses
 
Estimated fair value
Available-for-sale securities:
 
 
 
 
 
 
 
 
U.S. treasury
 
$
5,087

 
$
0

 
$
49

 
$
5,038

Government sponsored entities
 
2,001

 
3

 
0

 
2,004

States & political subdivisions
 
249,494

 
7,357

 
1,723

 
255,128

Corporate debt securities
 
323,975

 
3,196

 
1,002

 
326,169

Residential mortgage-backed securities
 
14,918

 
58

 
177

 
14,799

Commercial mortgage-backed securities
 
38,718

 
68

 
881

 
37,905

Collateralized debt obligations
 
70,461

 
453

 
82

 
70,832

Other debt securities
 
2,000

 
2

 
0

 
2,002

Total fixed maturities
 
706,654

 
11,137

 
3,914

 
713,877

Common stock
 
6,152

 
0

 
160

 
5,992

Total available-for-sale securities
 
$
712,806

 
$
11,137

 
$
4,074

 
$
719,869

 

 
 
At December 31, 2016
(in thousands)
 
Amortized
cost
 
Gross unrealized gains
 
Gross unrealized losses
 
Estimated fair value
Available-for-sale securities:
 
 
 
 
 
 
 
 
U.S. treasury
 
$
5,093

 
$
0

 
$
62

 
$
5,031

Government sponsored entities
 
2,004

 
22

 
0

 
2,026

States & political subdivisions
 
249,312

 
6,113

 
2,293

 
253,132

Corporate debt securities
 
321,041

 
3,293

 
1,386

 
322,948

Residential mortgage-backed securities
 
16,232

 
61

 
191

 
16,102

Commercial mortgage-backed securities
 
37,723

 
59

 
933

 
36,849

Collateralized debt obligations
 
68,998

 
351

 
96

 
69,253

Other debt securities
 
2,000

 
0

 
0

 
2,000

Total fixed maturities
 
702,403

 
9,899

 
4,961

 
707,341

Common stock
 
6,152

 
0

 
202

 
5,950

Total available-for-sale securities
 
$
708,555

 
$
9,899

 
$
5,163

 
$
713,291

 
 
The amortized cost and estimated fair value of fixed maturities at March 31, 2017 are shown below by remaining contractual term to maturity.  Mortgage-backed securities are allocated based upon their 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, 2017
(in thousands)
 
Amortized
 
Estimated
 
 
cost
 
fair value
Due in one year or less
 
$
76,219

 
$
76,354

Due after one year through five years
 
305,334

 
308,833

Due after five years through ten years
 
216,377

 
220,453

Due after ten years
 
108,724

 
108,237

Total fixed maturities
 
$
706,654

 
$
713,877




15

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, 2017
(dollars in thousands)
 
Less than 12 months
 
12 months or longer
 
Total
 
 
Fair
value
 
Unrealized losses
 
Fair
value
 
Unrealized losses
 
Fair
 value
 
Unrealized losses
 
No. of holdings
Available-for-sale securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. treasury
 
$
5,038

 
$
49

 
$
0

 
$
0

 
$
5,038

 
$
49

 
1

States & political subdivisions
 
52,740

 
1,723

 
0

 
0

 
52,740

 
1,723

 
22

Corporate debt securities
 
114,334

 
780

 
9,337

 
222

 
123,671

 
1,002

 
159

Residential mortgage-backed securities
 
6,555

 
57

 
4,621

 
120

 
11,176

 
177

 
11

Commercial mortgage-backed securities
 
28,986

 
496

 
2,692

 
385

 
31,678

 
881

 
28

Collateralized debt obligations
 
21,331

 
71

 
1,105

 
11

 
22,436

 
82

 
10

Total fixed maturities
 
228,984

 
3,176

 
17,755

 
738

 
246,739

 
3,914

 
231

Common stock
 
5,992

 
160

 
0

 
0

 
5,992

 
160

 
1

Total available-for-sale securities
 
$
234,976

 
$
3,336

 
$
17,755

 
$
738

 
$
252,731

 
$
4,074

 
232

Quality breakdown of fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Investment grade
 
$
219,190

 
$
2,993

 
$
14,437

 
$
539

 
$
233,627

 
$
3,532

 
180

Non-investment grade
 
9,794

 
183

 
3,318

 
199

 
13,112

 
382

 
51

Total fixed maturities
 
$
228,984

 
$
3,176

 
$
17,755

 
$
738

 
$
246,739

 
$
3,914

 
231



 
 
At December 31, 2016
(dollars in thousands)
 
Less than 12 months
 
12 months or longer
 
Total
 
 
Fair
value
 
Unrealized
losses
 
Fair
value
 
Unrealized
losses
 
Fair
value
 
Unrealized
losses
 
No. of
holdings
Available-for-sale securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. treasury
 
$
5,031

 
$
62

 
$
0

 
$
0

 
$
5,031

 
$
62

 
1

States & political subdivisions
 
84,611

 
2,293

 
0

 
0

 
84,611

 
2,293

 
40

Corporate debt securities
 
112,453

 
987

 
8,692

 
399

 
121,145

 
1,386

 
155

Residential mortgage-backed securities
 
7,451

 
60

 
4,974

 
131

 
12,425

 
191

 
13

Commercial mortgage-backed securities
 
26,509

 
437

 
4,319

 
496

 
30,828

 
933

 
28

Collateralized debt obligations
 
27,470

 
75

 
4,208

 
21

 
31,678

 
96

 
15

Total fixed maturities
 
263,525

 
3,914

 
22,193

 
1,047

 
285,718

 
4,961

 
252

Common stock
 
5,950

 
202

 
0

 
0

 
5,950

 
202

 
1

Total available-for-sale securities
 
$
269,475

 
$
4,116

 
$
22,193

 
$
1,047

 
$
291,668

 
$
5,163

 
253

Quality breakdown of fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Investment grade
 
$
239,041

 
$
3,605

 
$
16,061

 
$
399

 
$
255,102

 
$
4,004

 
136

Non-investment grade
 
24,484

 
309

 
6,132

 
648

 
30,616

 
957

 
116

Total fixed maturities
 
$
263,525

 
$
3,914

 
$
22,193

 
$
1,047

 
$
285,718

 
$
4,961

 
252

 
 
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 with the impairment charges recognized in earnings.


16

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:

(in thousands)
 
Three months ended March 31,
 
 
2017
 
2016
Fixed maturities
 
$
5,904

 
$
4,526

Equity securities
 
32

 
35

Cash equivalents and other
 
521

 
324

Total investment income
 
6,457

 
4,885

Less: investment expenses
 
479

 
223

Net investment income
 
$
5,978

 
$
4,662

 
 
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:

(in thousands)
 
Three months ended March 31,
 
 
2017
 
2016
Available-for-sale securities:
 
 

 
 

Fixed maturities:
 
 

 
 

Gross realized gains
 
$
580

 
$
134

Gross realized losses
 
(158
)
 
(1,583
)
Net realized gains (losses)
 
422

 
(1,449
)
Equity securities:
 


 
 

Gross realized losses
 
0

 
(34
)
Net realized losses
 
0

 
(34
)
Trading securities:
 


 
 

Common stock:
 


 
 

Increases in fair value(1)
 
0

 
395

Net realized gains
 
0

 
395

Miscellaneous:
 


 


Gross realized gains
 
94

 
0

Gross realized losses
 
0

 
0

Net realized gains
 
94

 
0

Net realized investment gains (losses)
 
$
516

 
$
(1,088
)
 
(1)
The fair value of our common stocks is determined based upon exchange traded prices provided by a nationally recognized pricing service.
 
 
Net impairment losses
The components of other-than-temporary impairments on investments were as follows:

(in thousands)
 
Three months ended March 31,
 
 
2017
 
2016
Fixed maturities
 
$
(121
)

$
(345
)
Total other-than-temporary impairments
 
(121
)

(345
)
Portion recognized in other comprehensive income
 
0


0

Net impairment losses recognized in earnings
 
$
(121
)

$
(345
)
 
 
In considering if fixed maturity securities were credit-impaired, some of the factors considered include: potential for the default of interest and/or principal, level of subordination, collateral of the issue, compliance with financial covenants, credit ratings and industry conditions.  We have the intent to sell all credit-impaired fixed maturity securities; therefore, the entire amount of the impairment charges were included in earnings and no non-credit impairments were recognized in other comprehensive income.


17

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, 2017 are comprised of partnership financial results for the fourth quarter of 2016.  Given the lag in reporting, our limited partnership results do not reflect the market conditions of the first quarter of 2017. 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 earnings (losses) of limited partnerships by method of accounting are included below:
 
(in thousands)
 
Three months ended March 31,
 
 
2017
 
2016
 
 
 
 
 
Equity in earnings (losses) of limited partnerships accounted for under the equity method
 
$
250

 
$
(716
)
Change in fair value of limited partnerships accounted for under the fair value option
 
(37
)
 
46

Equity in earnings (losses) of limited partnerships
 
$
213

 
$
(670
)


The following table summarizes limited partnership investments by sector:

(in thousands)
 
At March 31, 2017
 
At December 31, 2016
Private equity
 
$
35,510

 
$
35,228

Mezzanine debt
 
5,365

 
6,010

Real estate
 
9,206

 
12,509

Real estate - fair value option
 
4,376

 
4,412

Total limited partnership investments
 
$
54,457

 
$
58,159



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

 

18

Note 6.  Borrowing Arrangements
 
Bank line of credit
As of March 31, 2017, 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, 2017, 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, 2017.  Bonds with a fair value of $110.6 million were pledged as collateral on the line at March 31, 2017. 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, 2017. The bank requires compliance with certain covenants, which include leverage ratios and debt restrictions, for our line of credit.  We are in compliance with all bank covenants at March 31, 2017.

Term loan credit facility
On November 7, 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. As of March 31, 2017, we have drawn $25 million against the facility. Bonds with a fair value of $108.7 million were pledged as collateral for the facility and are reported as available-for-sale securities in the Statements of Financial Position as of March 31, 2017. 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, 2017.
 
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, 2017 was $23.4 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, 2017.
 
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 and $92.0 million thereafter.



19

Note 7.  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 reimburses us for approximately 58% of the annual benefit expense of these plans, which represents pension benefits for our employees performing claims and life insurance functions and their share of service department costs.
 
A $19.0 million contribution was made to the defined benefit pension plan in the first quarter of 2017. 

Prior to 2003, the employee pension plan purchased annuities from Erie Family Life Insurance Company ("EFL"), a wholly owned subsidiary of the Exchange, 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 $20.5 million at March 31, 2017 exists in the event EFL does not honor the annuity contracts.
 
The cost of our pension plans are as follows:
(in thousands)
 
Three months ended March 31,
 
 
2017
 
2016
Service cost for benefits earned
 
$
7,777

 
$
7,050

Interest cost on benefits obligation
 
8,569

 
8,281

Expected return on plan assets
 
(10,317
)
 
(9,880
)
Prior service cost amortization
 
218

 
174

Net actuarial loss amortization
 
2,325

 
2,028

Pension plan cost (1)
 
$
8,572

 
$
7,653

 
(1)
Pension plan costs represent the total cost before reimbursements to Indemnity from the Exchange and EFL.


Note 8.  Income Taxes

The effective tax rates differ from the statutory federal tax rate of 35% primarily due to permanent differences for tax exempt interest income.
 

Note 9.  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, 2017 and the year ended December 31, 2016. 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 October 2011, our Board of Directors approved a continuation of the current stock repurchase program for a total of $150 million, with no time limitation.  There were no shares repurchased under this program during the three months ended March 31, 2017 and the year ended December 31, 2016. We had approximately $17.8 million of repurchase authority remaining under this program at March 31, 2017.
 
During the three months ended March 31, 2017, we purchased 6,447 shares of our outstanding Class A nonvoting common stock outside of our publicly announced share repurchase program at a total cost of $0.7 million. Of this amount, we purchased 3,785 shares of our outstanding Class A nonvoting common stock at a total cost of $0.4 million, or $111.55 per share, for stock-based awards in conjunction with our equity compensation plan. These shares were delivered to plan participants in January 2017. The remaining 2,662 shares of our outstanding Class A nonvoting common stock were purchased at a total cost of $0.3 million, or $118.69 per share, to fund the rabbi trust for the outside director deferred compensation plan. These shares were transferred to the rabbi trust in March 2017.


20

Note 10.  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:
(in thousands)
 
Three months ended
 
Three months ended
 
 
March 31, 2017
 
March 31, 2016
 
 
Before Tax

Income Tax

Net

 
Before Tax

Income Tax

Net

Investment securities:
 
 
 
 
 
 
 
 
AOCI, beginning of year
 
$
3,954

$
1,384

$
2,570

 
$
3,888

$
1,361

$
2,527

OCI before reclassifications
 
2,640

924

1,716

 
3,503

1,226

2,277

Realized investment (gains) losses
 
(422
)
(148
)
(274
)
 
1,483

519

964

Impairment losses
 
121

42

79

 
345

121

224

OCI
 
2,339

818

1,521

 
5,331

1,866

3,465

AOCI, end of year
 
$
6,293

$
2,202

$
4,091

 
$
9,219

$
3,227

$
5,992

 
 
 
 
 
 
 
 
 
Pension and other postretirement plans: (1)
 
 
 
 
 
 
 
 
AOCI (loss), beginning of year
 
$
(190,695
)
$
(66,744
)
$
(123,951
)
 
$
(152,910
)
$
(53,519
)
$
(99,391
)
OCI before reclassifications
 
0

0

0

 
0

0

0

Amortization of prior service costs
 
0

0

0

 
0

0

0

Amortization of net actuarial loss
 
0

0

0

 
0

0

0

OCI
 
0

0

0

 
0

0

0

AOCI (loss), end of year
 
$
(190,695
)
$
(66,744
)
$
(123,951
)
 
$
(152,910
)
$
(53,519
)
$
(99,391
)
 
 
 
 
 
 
 
 
 
Total
 
 
 
 
 
 
 
 
AOCI (loss), beginning of year
 
$
(186,741
)
$
(65,360
)
$
(121,381
)
 
$
(149,022
)
$
(52,158
)
$
(96,864
)
Investment securities
 
2,339

818

1,521

 
5,331

1,866

3,465

Pension and other postretirement plans
 
0

0

0

 
0

0

0

OCI
 
2,339

818

1,521

 
5,331

1,866

3,465

AOCI (loss), end of year
 
$
(184,402
)
$
(64,542
)
$
(119,860
)
 
$
(143,691
)
$
(50,292
)
$
(93,399
)

 
(1)
There are no comprehensive income items or amounts reclassified out of accumulated other comprehensive loss related to postretirement plan items during interim periods.
  

Note 11. Related Party

Office lease
We lease certain office space from the Exchange including the home office and three field office facilities.  On April 28, 2017, after securing approval from the Pennsylvania Insurance Department, a new home office lease was executed between the Exchange and Indemnity, which is retroactive to January 1, 2017, when the prior lease expired.  Under the new lease, rent is based on rental rates of like property in Erie, Pennsylvania and all operating expenses including utilities, cleaning, repairs, real estate taxes, property insurance and leasehold improvements will be the responsibility of the tenant (Indemnity).  This lease agreement expires December 31, 2021.  Under the previous lease, rents were determined considering returns on invested capital and included building operating and overhead costs.  Rent costs and related operating expenses of shared facilities are allocated between Indemnity, Exchange and EFL based upon usage or square footage occupied. Total rent and operating expenses are estimated at $17.4 million for 2017 and totaled $14.3 million in 2016.  In 2016, reimbursements from the Exchange and EFL related to the use of this space totaled $4.9 million.


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 affiliates. See also Note 1, "Nature of Operations". Management fee amounts and other reimbursements due from the Exchange and affiliates were $392.3 million and $378.5 million at March 31, 2017 and December 31, 2016, respectively.

21

Note 13.  Commitments and Contingencies
 
We have contractual commitments to invest up to $16.2 million related to our limited partnership investments at March 31, 2017.  These commitments are split among private equity securities of $6.7 million, mezzanine debt securities of $7.9 million, and real estate activities of $1.6 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, other than the disclosure made in Note 11, "Related Party" regarding the home office lease.

22

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, 2016, as contained in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on February 23, 2017.
 
 
INDEX
 

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION
 
"Safe Harbor" Statement under the Private Securities Litigation Reform Act of 1995:
Statements contained herein that are not historical fact are forward-looking statements and, as such, are subject to risks and uncertainties that could cause actual events and results to differ, perhaps materially, from those discussed herein.  Forward-looking statements relate to future trends, events or results and include, without limitation, statements and assumptions on which such statements are based that are related to our plans, strategies, objectives, expectations, intentions, and adequacy of resources.  Examples of forward-looking statements are discussions relating to premium and investment income, expenses, operating results, and compliance with contractual and regulatory requirements.  Forward-looking statements are not guarantees of future performance and involve risks and uncertainties that are difficult to predict.  Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in such forward-looking statements.  Among the risks and uncertainties, in addition to those set forth in our filings with the Securities and Exchange Commission, that could cause actual results and future events to differ from those set forth or contemplated in the forward-looking statements include the following:

•
dependence upon our relationship with the Exchange and the management fee under the agreement with the subscribers at the Exchange;
•
costs of providing services to the Exchange under the subscriber’s agreement and investments in new technology and systems;
•
credit risk from the Exchange;
•
dependence upon our relationship with the Exchange and the growth of the Exchange, including:
◦
general business and economic conditions;
◦
factors affecting insurance industry competition;
◦
dependence upon the independent agency system; and
◦
ability to maintain our reputation for customer service;
•
dependence upon our relationship with the Exchange and the financial condition of the Exchange, including:
◦
the Exchange’s ability to maintain acceptable financial strength ratings;
◦
factors affecting the quality and liquidity of the Exchange’s investment portfolio;
◦
changes in government regulation of the insurance industry;
◦
emerging claims and coverage issues in the industry; and
◦
severe weather conditions or other catastrophic losses, including terrorism;
•
ability to attract and retain talented management and employees;
•
ability to maintain uninterrupted business operations and difficulties with technology or data security breaches, including cyber attacks;
•
factors affecting the quality and liquidity of our investment portfolio;

23

•
our ability to meet liquidity needs and access capital; and
•
outcome of pending and potential litigation.

A forward-looking statement speaks only as of the date on which it is made and reflects our analysis only as of that date.  We undertake no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events, changes in assumptions, or otherwise.


RECENT ACCOUNTING STANDARDS
 
See Part I, Item 1. "Financial Statements - Note 2, Significant Accounting Policies, of Notes to Financial Statements" contained within this report for a discussion of adopted as well as other recently issued accounting standards and the impact on our financial statements if known.


OPERATING OVERVIEW
 
Overview
We serve as the attorney-in-fact for the subscribers (policyholders) at the Exchange, a reciprocal insurer that writes personal and commercial property and casualty insurance. Our primary function is to perform certain services relating to the sales, underwriting and issuance of policies on behalf of the Exchange.
 
The Exchange is a reciprocal insurance exchange, which is an unincorporated association of individuals, partnerships and corporations that agree to insure one another. Each applicant for insurance to the Exchange signs a subscriber's agreement, which contains an appointment of Indemnity as their attorney-in-fact to transact business on their behalf. Pursuant to the subscriber’s agreement and for its services as attorney-in-fact, we earn a management fee calculated as a percentage of the direct and assumed premiums written by the Exchange.

Our earnings are primarily driven by the management fee revenue generated for the services we provide relating to certain sales, underwriting, and issuance of policies for the Exchange.  The sales related services we provide to the Exchange include agent compensation and certain sales and advertising support services. Agent compensation includes scheduled commissions to agents based upon premiums written as well as additional commissions and bonuses to agents, which are earned by achieving targeted measures. Agent compensation generally comprises approximately two-thirds of our expenses. The underwriting services we provide include underwriting and policy processing. The remaining services we provide include customer service and administrative support. We also provide information technology services that support all the functions listed above.

By virtue of its legal structure as a reciprocal insurer, the Exchange does not have the ability to enter into contractual relationships and therefore Indemnity serves as the attorney-in-fact on behalf of the Exchange for all claims handling services, investment management services, and certain other common overhead and service department functions in accordance with the subscriber’s agreement. The amounts Indemnity incurs on behalf of the Exchange in this capacity are reimbursed to Indemnity from the Exchange at cost.

Our results of operations are tied to the growth and financial condition of the Exchange as the Exchange is our sole customer, and our earnings are largely generated from management fees based on the direct and assumed premiums written by the Exchange. The Exchange generates revenue by insuring preferred and standard risks, with personal lines comprising 71% of the 2016 direct and assumed written premiums and commercial lines comprising the remaining 29%.  The principal personal lines products are private passenger automobile and homeowners.  The principal commercial lines products are commercial multi-peril, commercial automobile and workers compensation.


24

Financial Overview
 
 
Three months ended March 31,
(dollars in thousands, except per share data)
 
2017
 
2016
 
% Change
 
 
(Unaudited)
 
 
 
Total operating revenue
 
$
399,316

 
$
374,728

 
6.6

%
Total operating expenses
 
332,782

 
307,063

 
8.4

 
Net revenue from operations
 
66,534

 
67,665

 
(1.7
)
 
Total investment income
 
6,586

 
2,559

 
NM

 
Interest expense, net
 
166

 
—

 
NM

 
Income before income taxes
 
72,954

 
70,224

 
3.9

 
Income tax expense
 
25,078

 
24,329

 
3.1

 
Net income
 
$
47,876

 
$
45,895

 
4.3

%
Net income per share - diluted
 
$
0.91

 
$
0.87

 
4.5

%
 
NM = not meaningful


Total operating revenue increased 6.6% in the first quarter of 2017 compared to the first quarter of 2016 driven by the increase in management fee revenue. The two components of management fee revenue are the management fee rate we charge, and the direct and assumed premiums written by the Exchange. The management fee rate was 25% for both 2017 and 2016. The direct and assumed premiums written by the Exchange increased 6.7% to $1.6 billion in the first quarter of 2017 compared to the first quarter of 2016.

Total operating expenses increased 8.4% in the first quarter of 2017 compared to the first quarter of 2016. The increase in operating expenses was driven by higher commissions, information technology-related professional fees, incentive compensation and underwriting costs.

Gross margin from operations was 16.7% in the first quarter of 2017 and 18.1% in the first quarter of 2016.

Total investment income increased $4.0 million in the first quarter of 2017 compared to the first quarter of 2016 driven by higher net investment income, coupled with realized investment gains and equity in earnings of limited partnerships.

General Conditions and Trends Affecting Our Business
Economic conditions
Unfavorable changes in economic conditions, including declining consumer confidence, inflation, high unemployment, and the threat of recession, among others, may lead the Exchange’s customers to modify coverage, not renew policies, or even cancel policies, which could adversely affect the premium revenue of the Exchange, and consequently our management fee.  Further, unanticipated increased inflation costs including medical cost inflation, construction and auto repair cost inflation, and tort issues may impact the estimated loss reserves and future premium rates. If any of these items impacted the financial condition or continuing operations of the Exchange, it could have an impact on our financial results.
 
Financial market volatility
Our portfolio of fixed maturity, equity security, and limited partnership investments is subject to market volatility especially in periods of instability in the worldwide financial markets.  Over time, net investment income could also be impacted by volatility and by the general level of interest rates, which impact reinvested cash flow from the portfolio and business operations. Depending upon market conditions, which are unpredictable and remain uncertain, considerable fluctuation could exist in the fair value of our investment portfolio and reported total investment income, which could have an adverse impact on our financial condition, results of operations, and cash flows.




25

RESULTS OF OPERATIONS 
 
We earn management fee revenue from providing services relating to the sales, underwriting, and issuance of policies on behalf of the Exchange as a result of its attorney-in-fact relationship.   A summary of the financial results of these operations is as follows: 
 
 
Three months ended March 31,
(dollars in thousands)
 
2017
2016
% Change
 
 
(Unaudited)
 
 
Management fee revenue, net
 
$
392,058

$
367,458

6.7

%
Service agreement revenue
 
7,258

7,270

(0.2
)
 
Total operating revenue
 
399,316

374,728

6.6

 
Total operating expenses
 
332,782

307,063

8.4

 
Net revenue from operations
 
$
66,534

$
67,665

(1.7
)
%
Gross margin
 
16.7
%
18.1
%
(1.4
)
pts.
 

Management fee revenue
Management fee revenue is based upon all direct and assumed premiums written by the Exchange and the management fee rate, which is determined by our Board of Directors at least annually.  The management fee rate was set at 25%, the maximum rate, for both 2017 and 2016.  Changes in the management fee rate can affect our revenue and net income significantly. Management fee revenue is calculated by multiplying the management fee rate by the direct and assumed premiums written by the Exchange.  The following table presents the calculation of management fee revenue: 
 
 
Three months ended March 31,
(dollars in thousands)
 
2017
2016
% Change
 
 
(Unaudited)
 
 
Direct and assumed premiums written by the Exchange
 
$
1,573,031

$
1,474,632

6.7
%
Management fee rate
 
25
%
25
%
 
 
Management fee revenue, gross
 
393,258

368,658

6.7
 
Change in allowance for management fee returned on cancelled policies(1)
 
(1,200
)
(1,200
)
NM
 
Management fee revenue, net of allowance
 
$
392,058

$
367,458

6.7
%
 
NM = not meaningful

(1)
Management fees are returned to the Exchange when policies are cancelled mid-term and unearned premiums are refunded.  We record an estimated allowance for management fees returned on mid-term policy cancellations.


Direct and assumed premiums written by the Exchange
Direct and assumed premiums include premiums written directly by the Exchange and premiums assumed from its wholly owned property and casualty subsidiaries. Direct and assumed premiums written by the Exchange increased 6.7% to $1.6 billion in the first quarter of 2017 compared to the first quarter of 2016, driven by increases in both policies in force and average premium per policy.  Year-over-year policies in force for all lines of business increased 3.2% in the first quarter of 2017 as the result of continuing strong policyholder retention and an increase in new policies written, compared to 3.6% in the first quarter of 2016.  The year-over-year average premium per policy for all lines of business increased 2.8% at March 31, 2017, compared to 3.4% at March 31, 2016.

Premiums generated from new business increased 12.2% to $202 million in the first quarter of 2017, compared to an increase of 6.8% to $180 million in the first quarter of 2016.  Underlying the trend in new business premiums was a 7.4% increase in new business policies written in the first quarter of 2017, compared to a 4.8% increase in the first quarter of 2016, while the year-over-year average premium per policy on new business increased 3.6% at March 31, 2017, compared to 1.2% at March 31, 2016. Premiums generated from renewal business increased 5.9% to $1.4 billion in the first quarter of 2017, compared to an increase of 7.1% to $1.3 billion in the first quarter of 2016.  Underlying the trend in renewal business premiums was an increase in year-over-year average premium per policy of 2.6% at March 31, 2017, compared to 3.7% at March 31, 2016, and steady policy retention ratios. 


26

Personal lines – Total personal lines premiums written increased 7.7% to $1.1 billion in the first quarter of 2017, from $1.0 billion in the first quarter of 2016, driven by an increase of 3.3% in total personal lines policies in force and an increase of 3.3% in the total personal lines year-over-year average premium per policy.

Commercial lines – Total commercial lines premiums written increased 4.4% to $502 million in the first quarter of 2017, from $481 million in the first quarter of 2016, driven by a 2.5% increase in total commercial lines policies in force and a 2.1% increase in the total commercial lines year-over-year average premium per policy. 

Future trends-premium revenue – The Exchange plans to continue its efforts to grow premiums and improve its competitive position in the marketplace.  Expanding the size of its agency force through a careful agency selection process and increased market penetration in our existing operating territories will contribute to future growth as existing and new agents build their books of business.

Changes in premium levels attributable to the growth in policies in force and rate changes directly affect the profitability of the Exchange and have a direct bearing on our management fee. The Exchange's continued focus on underwriting discipline and the maturing of its pricing sophistication models has contributed to its growth in new policies in force, steady policy retention ratios, and increased average premium per policy.

Service agreement revenue
Service agreement revenue includes service charges we collect from policyholders for providing extended payment terms on policies written and assumed by the Exchange, and late payment and policy reinstatement fees.  The service charges are fixed dollar amounts per billed installment.  Service agreement revenue totaled $7.3 million in both the first quarter of 2017 and 2016.  While policies in force continue to grow, service agreement revenue remained comparable. This reflects the continued shift in policies to the monthly direct debit payment plan, which does not incur service charges, and the no-fee single payment plan, which offers a premium discount.  The shift to these plans is driven by the consumers’ desire to avoid paying service charges and to take advantage of the discount in pricing offered for paid-in-full policies.

Cost of operations
 
 
Three months ended March 31,
(in thousands)
 
2017
2016
% Change
 
 
(Unaudited)
 
Commissions:
 
 
 
 
Total commissions
 
$
220,478

$
208,714

5.6
 %
Non-commission expense:
 
 
 
 
Underwriting and policy processing
 
$
35,448

$
33,488

5.9
 %
Information technology
 
34,800

28,384

22.6

Sales and advertising
 
13,597

14,449

(5.9
)
Customer service
 
6,634

7,029

(5.6
)
Administrative and other
 
21,825

14,999

45.5

Total non-commission expense
 
112,304

98,349

14.2

Total cost of operations
 
$
332,782

$
307,063

8.4
 %


Commissions – Commissions increased $11.8 million in the first quarter of 2017 compared to the same period in 2016. The increase was driven by the 6.7% increase in direct and assumed premiums written by the Exchange.

Non-commission expense – Non-commission expense increased $14.0 million in the first quarter of 2017 compared to the same period in 2016.  Information technology costs increased $6.4 million primarily due to increased professional fees. Underwriting and policy processing costs increased $2.0 million primarily due to the increased cost of underwriting reports. Administrative and other expenses increased $6.8 million driven by increased personnel costs, including higher incentive plan costs, increased pension plan expenses and increased earnings on deferred compensation.  The incentive plan cost increase was driven by the long-term incentive plan due to the increase in the company stock price during the quarter.  Additionally, the employee incentive plan program was expanded to additional employee groups beginning in 2017. All other operating costs decreased $1.2 million.

Gross margin
The gross margin in the first quarter of 2017 was 16.7% compared to 18.1% in the first quarter of 2016.


27

Total investment income
A summary of the results of our investment operations is as follows:
(in thousands)
 
Three months ended March 31,
 
 
2017
 
2016
 
% Change
 
 
(Unaudited)
 
 
 
Net investment income
 
$
5,978

 
$
4,662

 
28.2
%
Net realized investment gains (losses)
 
516

 
(1,088
)
 
NM
 
Net impairment losses recognized in earnings
 
(121
)
 
(345
)
 
64.8
 
Equity in earnings (losses) of limited partnerships
 
213

 
(670
)
 
NM
 
Total investment income
 
$
6,586

 
$
2,559

 
NM
%

NM = not meaningful
 
 
Net investment income
Net investment income primarily includes interest and dividends on our fixed maturity and equity security portfolios, net of investment expenses. 
 
Net investment income increased $1.3 million in the first quarter of 2017, compared to the first quarter of 2016, primarily due to an increase in the invested balances and yields of fixed maturity securities.

Net realized investments gains (losses)
A breakdown of our net realized investment gains (losses) is as follows: 
(in thousands)
 
Three months ended March 31,
 
 
2017
 
2016
Securities sold:
 
(Unaudited)
Fixed maturities
 
$
422

 
$
(1,449
)
Equity securities
 
0

 
(34
)
Common stock increases in fair value(1)
 
0

 
395

Miscellaneous
 
94

 
0

Net realized investment gains (losses)(2)
 
$
516

 
$
(1,088
)
 

(1)
The fair value of our common stocks is determined based upon exchange traded prices provided by a nationally recognized pricing service.
 
(2)
See Part I, Item 1. "Financial Statements - Note 5, Investments, of Notes to Financial Statements" contained within this report for additional disclosures regarding net realized investment gains (losses.)


Net realized investment gains and losses include gains and losses resulting from the sales of our fixed maturity or equity securities, as well as changes in fair value of common stocks designated as trading securities. 

Net realized gains of $0.5 million during the first quarter of 2017 were driven by sales of fixed maturity securities, while net realized losses of $1.1 million in the first quarter of 2016 resulted from losses on sales of fixed maturity securities, partially offset by increases in fair value of common stock designated at trading securities.

Net impairment losses recognized in earnings
Net impairment losses recorded in earnings were $0.1 million for the first quarter of 2017, compared to $0.3 million in the first quarter of 2016. Impairments in both periods were primarily related to several securities in an unrealized loss position where we determined the loss was other-than-temporary based on credit factors.



28

Equity in earnings (losses) of limited partnerships
The components of equity in earnings (losses) of limited partnerships are as follows:
 
(in thousands)
 
Three months ended March 31,
 
 
2017
 
2016
 
 
(Unaudited)
Private equity
 
$
551

 
$
(1,309
)
Mezzanine debt
 
(146
)
 
(217
)
Real estate
 
(192
)
 
856

Total equity in earnings (losses) of limited partnerships
 
$
213

 
$
(670
)
 
 
Limited partnership earnings pertain to investments in U.S. and foreign private equity, mezzanine debt, and real estate partnerships.  Valuation adjustments are recorded to reflect the changes in fair value of the underlying investments held by the limited partnerships.  These adjustments are recorded as a component of equity in earnings (losses) of limited partnerships in the Statements of Operations.

Limited partnership earnings tend to be cyclical based upon market conditions, the age of the partnership, and the nature of the investments.  Generally, limited partnership earnings are recorded on a quarter lag from financial statements we receive from our general partners.  As a consequence, earnings from limited partnerships reported at March 31, 2017 reflect investment valuation changes resulting from the financial markets and the economy in the fourth quarter of 2016.

Equity in earnings of limited partnerships increased by $0.9 million in the first quarter of 2017, compared to the first quarter of 2016. The increase in earnings in 2017 was primarily due to higher earnings from private equity investments, partially offset by lower earnings from real estate investments.

Financial condition of Erie Insurance Exchange
Serving in the capacity of attorney-in-fact for the Exchange, we are dependent on the growth and financial condition of the Exchange, who is our sole customer. The strength of the Exchange and its wholly owned subsidiaries is rated annually by A.M. Best Company. Higher ratings of insurance companies generally indicate financial stability and a strong ability to pay claims. The ratings are generally based upon factors relevant to policyholders and are not directed toward return to investors. The Exchange and each of its property and casualty subsidiaries are rated A+ "Superior". As of December 31, 2016, the outlook for the financial strength rating was affirmed as stable. According to A.M. Best, this second highest financial strength rating category is assigned to those companies that, in A.M. Best’s opinion, have achieved superior overall performance when compared to the standards established by A.M. Best and have a superior ability to meet obligations to policyholders over the long term. As of December 31, 2016, only approximately 11% of insurance groups are rated A+ or higher, and the Exchange is included in that group.

The financial statements of the Exchange are prepared in accordance with statutory accounting principles prescribed by the Commonwealth of Pennsylvania. Financial statements prepared under statutory accounting principles focus on the solvency of the insurer and generally provide a more conservative approach than under GAAP. Statutory direct written premiums of the Exchange and its wholly owned property and casualty subsidiaries grew 6.7% to $1.6 billion in the first quarter of 2017 from $1.5 billion in the first quarter of 2016. These premiums, along with investment income, are the major sources of cash that support the operations of the Exchange. Policyholders’ surplus, determined under statutory accounting principles, was $7.9 billion at March 31, 2017, $7.7 billion at December 31, 2016, and $7.2 billion at March 31, 2016. The Exchange and its wholly owned property and casualty subsidiaries' year-over-year policy retention ratio continues to be high at 89.8% at March 31, 2017 and December 31, 2016, and 89.9% at March 31, 2016.



29

FINANCIAL CONDITION
 
Investments
Our investment portfolio is managed with the objective of maximizing after-tax returns on a risk-adjusted basis.
 
Distribution of investments
 
 
 
Carrying value at
 
 
 
Carrying value at
 
 
(dollars in thousands)
 
March 31, 2017
 
% to total
 
December 31, 2016
 
% to total
 
 
(Unaudited)
 
 

 
 

Fixed maturities
 
$
713,877

 
92
%
 
$
707,341

 
90
%
Common stock
 
5,992

 
1

 
5,950

 
1

Limited partnerships:
 
 
 
 
 
 
 
 
Private equity
 
35,510

 
4

 
35,228

 
5

Mezzanine debt
 
5,365

 
1

 
6,010

 
1

Real estate
 
13,582

 
2

 
16,921

 
3

Real estate mortgage loans (1)
 
195

 
0

 
213

 
0

Total investments
 
$
774,521

 
100
%
 
$
771,663

 
100
%
(1)     Real estate mortgage loans are included with Other assets in the Statements of Financial Position.
    
We continually review our investment portfolio to evaluate positions that might incur other-than-temporary declines in value. We record impairment write-downs on investments in instances where the fair value of the investment is substantially below cost, and we conclude that the decline in fair value is other-than-temporary, which includes consideration for intent to sell.  For all investment holdings, general economic conditions and/or conditions specifically affecting the underlying issuer or its industry, including downgrades by the major rating agencies, are considered in evaluating impairment in value.  In addition to specific factors, other factors considered in our review of investment valuation are the length of time the fair value is below cost and the amount the fair value is below cost.
 
We individually analyze all positions with emphasis on those that have, in management’s opinion, declined significantly below cost.  In compliance with impairment guidance for debt securities, we perform further analysis to determine if a credit-related impairment has occurred.  Some of the factors considered in determining whether a debt security is credit impaired include potential for the default of interest and/or principal, level of subordination, collateral of the issue, compliance with financial covenants, credit ratings and industry conditions.  We have the intent to sell all credit-impaired debt securities; therefore, the entire amount of the impairment charges is included in earnings and no impairments are recorded in other comprehensive income.  For available-for-sale equity securities, a charge is recorded in the Statements of Operations for positions that have experienced other-than-temporary impairments.  (See the "Results of Operations" section contained within this report for further information.)  Management believes its investment valuation philosophy and accounting practices result in appropriate and timely measurement of value and recognition of impairment.

Fixed maturities
Under our investment strategy, we maintain a fixed maturity portfolio that is of high quality and well diversified within each market sector.  This investment strategy also achieves a balanced maturity schedule.  Our fixed maturity portfolio is managed with the goal of achieving reasonable returns while limiting exposure to risk.  Our municipal bond portfolio accounts for $255.1 million, or 36%, of the total fixed maturity portfolio at March 31, 2017.  The overall credit rating of the municipal portfolio without consideration of the underlying insurance is AA+.

Fixed maturities classified as available-for-sale are carried at fair value with unrealized gains and losses, net of deferred taxes, included in shareholders’ equity.  Net unrealized gains on fixed maturities, net of deferred taxes, amounted to $4.7 million at March 31, 2017, compared to $3.2 million at December 31, 2016.
 

30

The following table presents a breakdown of the fair value of our fixed maturity portfolio by sector and rating: (1) 
 
 
At March 31, 2017
(in thousands)
 
(Unaudited)
Industry Sector
 
AAA
 
AA
 
A
 
BBB
 
Non- investment
grade
 
Fair
value
Basic materials
 
$
0

 
$
0

 
$
0

 
$
210

 
$
12,135

 
$
12,345

Communications
 
0

 
0

 
2,006

 
8,426

 
20,962

 
31,394

Consumer
 
0

 
0

 
4,531

 
29,647

 
45,413

 
79,591

Diversified
 
0

 
0

 
0

 
0

 
598

 
598

Energy
 
0

 
5,019

 
5,498

 
5,587

 
13,900

 
30,004

Financial
 
0

 
6,992

 
25,653

 
60,492

 
15,869

 
109,006

Government-municipal
 
110,591

 
134,870

 
8,661

 
1,006

 
0

 
255,128

Government sponsored entities
 
0

 
2,004

 
0

 
0

 
0

 
2,004

Industrial
 
0

 
0

 
1,849

 
4,020

 
19,731

 
25,600

Structured securities(2)
 
66,449

 
31,975

 
13,954

 
4,928

 
8,232

 
125,538

Technology
 
0

 
6,970

 
2,179

 
4,074

 
13,227

 
26,450

U.S. Treasury
 
5,038

 
0

 
0

 
0

 
0

 
5,038

Utilities
 
0

 
0

 
2,000

 
7,990

 
1,191

 
11,181

Total
 
$
182,078

 
$
187,830

 
$
66,331

 
$
126,380

 
$
151,258

 
$
713,877

 
(1)
 Ratings are supplied by S&P, Moody’s, and Fitch.  The table is based upon the lowest rating for each security.
 
(2)
Structured securities include residential mortgage-backed securities, commercial mortgage-backed securities, collateralized debt obligations, and asset-backed securities.


Common stock
Equity securities classified as available-for-sale include certain exchange traded funds with underlying holdings of fixed maturity securities. These securities meet the criteria of a common stock under U.S. GAAP, and are included on the Statements of Financial Position as available-for-sale equity securities. These investments are carried at fair value of $6.0 million at March 31, 2017 and $5.9 million at December 31, 2016, with all changes in unrealized gains and losses reflected in other comprehensive income.  The net unrealized loss on these securities, net of deferred taxes, was $0.1 million at March 31, 2017 and December 31, 2016.

Limited partnerships
In the first quarter of 2017, investments in limited partnerships decreased from the investment levels at December 31, 2016.  Changes in partnership values are a function of contributions and distributions, adjusted for market value changes in the underlying investments. The decrease in limited partnership investments was primarily due to net distributions received from the partnerships. We have made no new limited partnership commitments since 2006, and the balance of limited partnership investments is expected to decline over time as additional distributions are received. The results from our limited partnerships are based upon financial statements received from our general partners, which are generally received on a quarter lag.  As a result, the market values and earnings recorded during the first quarter of 2017 reflect the partnership activity experienced in the fourth quarter of 2016.
 
 
 


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LIQUIDITY AND CAPITAL RESOURCES
 
Sources and Uses of Cash
Liquidity is a measure of a company’s ability to generate sufficient cash flows to meet the short- and long-term cash requirements of its business operations and growth needs.  Our liquidity requirements have been met primarily by funds generated from management fee revenue and income from investments.  Cash provided from these sources is used primarily to fund the costs of our operations including commissions, salaries and wages, pension plans, share repurchases, dividends to shareholders, and the purchase and development of information technology.  We expect that our operating cash needs will be met by funds generated from operations.

Volatility in the financial markets presents challenges to us as we do occasionally access our investment portfolio as a source of cash.  Some of our fixed income investments, despite being publicly traded, are illiquid.  Volatility in these markets could limit our ability to sell certain of our fixed income securities or cause such securities to sell at deep discounts.  Additionally, our limited partnership investments are significantly less liquid.  We believe we have sufficient liquidity to meet our needs from sources other than the liquidation of securities.
 
Cash flow activities
The following table provides condensed cash flow information for the three months ended March 31:
(in thousands)
 
2017
 
2016
 
 
(Unaudited)
Net cash used in operating activities
 
$
(35,122
)
 
$
(21,762
)
Net cash used in investing activities
 
(7,081
)
 
(21,849
)
Net cash used in financing activities
 
(36,451
)
 
(33,996
)
Net decrease in cash and cash equivalents
 
$
(78,654
)
 
$
(77,607
)
 
 
Net cash used in operating activities was $35.1 million in the first three months of 2017, compared to $21.8 million in the first three months of 2016.  Increased cash used in operating activities for the first three months of 2017 was primarily due to an increase in commissions and bonuses paid to agents and general operating expenses paid, combined with a decrease in reimbursements collected from affiliates compared to the first three months of 2016. Cash paid for agent commissions and bonuses increased $17.4 million to $293.9 million in the first three months of 2017 due to higher scheduled commissions driven by premium growth and higher bonus award payments resulting from profitable underwriting results. Somewhat offsetting this increase in cash used was an increase in management fee revenue received, reflecting the increase in direct and assumed premiums written by the Exchange, compared to the first three months of 2016. We contributed $19.0 million to our pension plan in the first quarter of 2017, compared to $17.4 million in the first quarter of 2016.  Our funding policy is generally to contribute an amount equal to the greater of the target normal cost for the plan year or the amount necessary to fund the plan to 100% plus interest to the date the contribution is made.  We are reimbursed approximately 58% of the net periodic benefit cost of the pension plans from the Exchange, which represents pension benefits for our employees performing claims and life insurance functions and their share of service department costs. At March 31, 2017, we recorded a net deferred tax asset of $52.5 million.  There was no deferred tax valuation allowance recorded at March 31, 2017.
 
Net cash used in investing activities totaled $7.1 million in the first three months of 2017, compared to $21.8 million in the first three months of 2016. The decrease in cash used for the first three months of 2017, compared to the first three months of 2016, was driven by more cash being generated from the sale and maturity of available-for-sale securities. Also impacting our future investing activities are limited partnership commitments, which totaled $16.2 million at March 31, 2017, and will be funded as required by the partnerships’ agreements.  Of this amount, the total remaining commitment to fund limited partnerships that invest in private equity securities was $6.7 million, mezzanine debt securities was $7.9 million and real estate activities was $1.6 million.

Net cash used in financing activities totaled $36.5 million in the first three months of 2017, compared to $34.0 million in the first three months of 2016, primarily due to dividends paid to shareholders.  We increased both our Class A and Class B shareholder regular quarterly dividends by 7.2% for 2017, compared to 2016.  There are no regulatory restrictions on the payment of dividends to our shareholders. Future financing activities will include the cash draws required under the senior secured draw term loan credit facility, which will increase the cash provided by financing activities by $50 million in 2017 and $25 million in 2018, while principal payments will not commence until 2019.
 
No shares of our Class A nonvoting common stock were repurchased in the first three months of 2017 and 2016 in conjunction with our stock repurchase program. In October 2011, our Board of Directors approved a continuation of the current stock

32

repurchase program for a total of $150 million with no time limitation.  This repurchase authority includes, and is not in addition to, any unspent amounts remaining under the prior authorization.  We had approximately $17.8 million of repurchase authority remaining under this program at March 31, 2017, based upon trade date.

In January 2017, we purchased 3,785 shares of our outstanding Class A nonvoting common stock outside of our publicly announced share repurchase program at a total cost of $0.4 million, or $111.55 per share, for stock-based awards in conjunction with our equity compensation plan. These shares were delivered to plan participants in January 2017.

In February 2017, we purchased 2,662 shares of our outstanding Class A nonvoting common stock outside of our publicly announced share repurchase program at a total cost of $0.3 million, or $118.69 per share, to fund the rabbi trust for the outside director deferred compensation plan. These shares were transferred to the rabbi trust in March 2017.

Capital Outlook
We regularly prepare forecasts evaluating the current and future cash requirements for both normal and extreme risk events.  Should an extreme risk event result in a cash requirement exceeding normal cash flows, we have the ability to meet our future funding requirements through various alternatives available to us.

Outside of our normal operating and investing cash activities, future funding requirements could be met through:
1) cash and cash equivalents, which total approximately $110.4 million at March 31, 2017, 2) a $100 million bank revolving line of credit, and 3) liquidation of unpledged assets held in our investment portfolio, including common stock and investment grade bonds, which totaled approximately $349.4 million at March 31, 2017.  Volatility in the financial markets could impair our ability to sell certain fixed income securities or cause such securities to sell at deep discounts.  Additionally, we have the ability to curtail or modify discretionary cash outlays such as those related to shareholder dividends and share repurchase activities.
 
As of March 31, 2017, 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, 2017, 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, 2017. Bonds with a fair value of $110.6 million were pledged as collateral on the line at March 31, 2017. These securities have no trading restrictions and are reported as available-for-sale securities in the Statements of Financial Position.  The bank requires compliance with certain covenants, which include leverage ratios and debt restrictions.  We were in compliance with our bank covenants at March 31, 2017.

Balance Sheet Arrangements
Off-balance sheet arrangements include those with unconsolidated entities that may have a material current or future effect on our financial condition or results of operations, including material variable interests in unconsolidated entities that conduct certain activities.  We have no material off-balance sheet obligations or guarantees, other than the unused portion of the senior secured draw term loan credit facility and limited partnership investment commitments.

Surplus Note
We hold a surplus note for $25 million from EFL that is payable on demand on or after December 31, 2018; however, no principal or interest payments may be made without prior approval by the Pennsylvania Insurance Commissioner.  Interest payments are scheduled to be paid semi-annually. For each of the three months ended March 31, 2017 and 2016, we recognized interest income on the note of $0.4 million.
 

TRANSACTIONS/AGREEMENTS WITH RELATED PARTIES

Leased Property
On April 28, 2017, after securing approval from the Pennsylvania Insurance Department, a new home office lease was executed between the Exchange and Indemnity, which is retroactive to January 1, 2017, when the prior lease expired.  Under the new lease, rent is based on rental rates of like property in Erie, Pennsylvania and all operating expenses including utilities, cleaning, repairs, real estate taxes, property insurance and leasehold improvements will be the responsibility of the tenant (Indemnity). Under the previous lease, rents were determined considering returns on invested capital and included building operating and overhead costs.  Rent costs and related operating expenses of shared facilities are allocated between Indemnity, Exchange and EFL based upon usage or square footage occupied.


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CRITICAL ACCOUNTING ESTIMATES
 
We make estimates and assumptions that have a significant effect on the amounts and disclosures reported in the financial statements.  The most significant estimates relate to investment valuation and retirement benefit plans for employees.  While management believes its estimates are appropriate, the ultimate amounts may differ from estimates provided.  Our most critical accounting estimates are described in Item 7. "Management’s Discussion and Analysis of Financial Condition and Results of Operations" for the year ended December 31, 2016 of our Annual Report on Form 10-K as filed with the Securities and Exchange Commission on February 23, 2017.  See Part I, Item 1. "Financial Statements - Note 4, Fair Value, of Notes to Financial Statements" contained within this report for additional information on our valuation of investments.


ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
Our exposure to market risk is primarily related to fluctuations in prices and interest rates.  Quantitative and qualitative disclosures about market risk resulting from changes in prices, interest rates, and other risk exposures for the year ended December 31, 2016 are included in Item 7A. "Quantitative and Qualitative Disclosures About Market Risk", of our Annual Report on Form 10-K as filed with the Securities and Exchange Commission on February 23, 2017.

There have been no material changes that impact our portfolio or reshape our periodic investment reviews of asset allocations during the three months ended March 31, 2017.  For a recent discussion of conditions surrounding our investment portfolio, see the "Operating Overview", "Results of Operations", and "Financial Condition" discussions contained in Part I, Item 2. "Management’s Discussion and Analysis of Financial Condition and Results of Operations" contained within this report.


ITEM 4.
CONTROLS AND PROCEDURES
 
We carried out an evaluation, with the participation of management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (pursuant to Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this report.  Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective.
 
Our management evaluated, with the participation of the Chief Executive Officer and Chief Financial Officer, any change in our internal control over financial reporting and determined there has been no change in our internal control over financial reporting during the three months ended March 31, 2017 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.


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PART II. OTHER INFORMATION

ITEM 1.
LEGAL PROCEEDINGS

State Court Lawsuit Against Erie Indemnity Company
Erie Indemnity Company (“Indemnity”) was named as a defendant in a complaint filed on August 1, 2012 by alleged subscribers of the Erie Insurance Exchange (the “Exchange”) in the Court of Common Pleas Civil Division of Fayette County, Pennsylvania captioned Erie Insurance Exchange, an unincorporated association, by Joseph S. Sullivan and Anita Sullivan, Patricia R. Beltz, and Jenna L. DeBord, trustees ad litem v. Erie Indemnity Co. (the “Sullivan” lawsuit).

As subsequently amended, the complaint alleges that, beginning on September 1, 1997, Indemnity retained “Service Charges” (installment fees) and “Added Service Charges” (late fees and policy reinstatement charges) on policies written by Exchange and its insurance subsidiaries, which allegedly should have been paid to Exchange, in the amount of approximately $308 million. In addition to their claim for monetary relief on behalf of Exchange, Plaintiffs seek an accounting of all so-called intercompany transactions between Indemnity and Exchange from 1996 to date. Plaintiffs allege that Indemnity breached its contractual, fiduciary, and equitable duties by retaining Service Charges and Added Service Charges that should have been retained by Exchange. Plaintiffs bring these same claims under three separate derivative-type theories. First, Plaintiffs purport to bring suit as members of Exchange on behalf of Exchange. Second, Plaintiffs purport to bring suit as trustees ad litem on behalf of Exchange. Third, Plaintiffs purport to bring suit on behalf of Exchange pursuant to Rule 1506 of the Pennsylvania Rules of Civil Procedure, which allows shareholders to bring suit derivatively on behalf of a corporation or similar entity.

Indemnity filed a motion in the state court in November 2012 seeking dismissal of the lawsuit. On December 19, 2013, the court granted Indemnity’s motion in part, holding that the Pennsylvania Insurance Holding Company Act “provides the [Pennsylvania Insurance] Department with special competence to address the subject matter of plaintiff’s claims” and referring “all issues” in the Sullivan lawsuit to the Pennsylvania Insurance Department (the “Department”) for “its views and any determination.” The court stayed all further proceedings and reserved decision on all other grounds for dismissal raised by Indemnity. Plaintiffs sought reconsideration of the court’s order, and on January 13, 2014, the court entered a revised order affirming its prior order and clarifying that the Department “shall decide any and all issues within its jurisdiction.” On January 30, 2014, Plaintiffs asked the court to certify its order to permit an immediate appeal to the Superior Court of Pennsylvania and to stay any proceedings in the Department pending completion of any appeal. On February 18, 2014, the court issued an order denying Plaintiffs’ motion. On March 20, 2014, Plaintiffs filed a petition for review with the Superior Court, which was denied by the Superior Court on May 5, 2014.

The Sullivan matter was assigned to an Administrative Judge within the Department for determination. The parties agreed that an evidentiary hearing was not required, entered into a stipulated record, and submitted briefing to the Department. Oral argument was held before the Administrative Judge on January 6, 2015. On April 29, 2015, the Department issued a declaratory opinion and order: (1) finding that the transactions between Exchange and Indemnity in which Indemnity retained or received revenue from installment and other service charges from Exchange subscribers complied with applicable insurance laws and regulations and that Indemnity properly retained charges paid by Exchange policyholders for certain installment premium payment plans, dishonored payments, policy cancellations, and policy reinstatements; and (2) returning jurisdiction over the matter to the Fayette County Court of Common Pleas.

On May 26, 2015, Plaintiffs appealed the Department’s decision to the Pennsylvania Commonwealth Court. Oral argument was held before the Commonwealth Court en banc on December 9, 2015. On January 27, 2016, the Commonwealth Court issued an opinion vacating the Department’s ruling and directing the Department to return the case to the Court of Common Pleas, essentially holding that the primary jurisdiction referral of the trial court was improper at this time because the allegations of the complaint do not implicate the special competency of the Department.

On February 26, 2016, Indemnity filed a petition for allowance of appeal to the Pennsylvania Supreme Court seeking further review of the Commonwealth Court opinion. On March 14, 2016, Plaintiffs filed an answer opposing Indemnity’s petition for allowance of appeal; and, on March 28, 2016, Indemnity sought permission to file a reply brief in further support of its petition for allowance of appeal. On August 10, 2016, the Pennsylvania Supreme Court denied Indemnity’s petition for allowance of appeal; and the Sullivan lawsuit returned to the Court of Common Pleas of Fayette County.

On September 12, 2016, Plaintiffs filed a motion to stay the Sullivan lawsuit pending the outcome of the Federal Court Lawsuit they filed against Indemnity and former and current Directors of Indemnity on July 8, 2016. (See below.) Indemnity filed an opposition to Plaintiff’s motion to stay on September 19, 2016; and filed amended preliminary objections seeking dismissal of the Sullivan lawsuit on September 20, 2016. The motion to stay and the amended preliminary objections remain pending.


35

Indemnity believes that it continues to have meritorious legal and factual defenses to the Sullivan lawsuit and intends to vigorously defend against all allegations and requests for relief.

Federal Court Lawsuit Against Directors
On February 6, 2013, a lawsuit was filed in the United States District Court for the Western District of Pennsylvania, captioned Erie Insurance Exchange, an unincorporated association, by members Patricia R. Beltz, Joseph S. Sullivan and Anita Sullivan, and Patricia R. Beltz, on behalf of herself and others similarly situate v. Richard L. Stover; J. Ralph Borneman, Jr.; Terrence W. Cavanaugh; Jonathan Hirt Hagen; Susan Hirt Hagen; Thomas B. Hagen; C. Scott Hartz; Claude C. Lilly, III; Lucian L. Morrison; Thomas W. Palmer; Martin P. Sheffield; Elizabeth H. Vorsheck; and Robert C. Wilburn (the “Beltz” lawsuit), by alleged policyholders of Exchange who are also the plaintiffs in the Sullivan lawsuit. The individuals named as defendants in the Beltz lawsuit were the then-current Directors of Indemnity.

As subsequently amended, the Beltz lawsuit asserts many of the same allegations and claims for monetary relief as in the Sullivan lawsuit. Plaintiffs purport to sue on behalf of all policyholders of Exchange, or, alternatively, on behalf of Exchange itself. Indemnity filed a motion to intervene as a Party Defendant in the Beltz lawsuit in July 2013, and the Directors filed a motion to dismiss the lawsuit in August 2013. On February 10, 2014, the court entered an order granting Indemnity’s motion to intervene and permitting Indemnity to join the Directors’ motion to dismiss; granting in part the Directors’ motion to dismiss; referring the matter to the Department to decide any and all issues within its jurisdiction; denying all other relief sought in the Directors’ motion as moot; and dismissing the case without prejudice. To avoid duplicative proceedings and expedite the Department’s review, the Parties stipulated that only the Sullivan action would proceed before the Department and any final and non-appealable determinations made by the Department in the Sullivan action will be applied to the Beltz action.

On March 7, 2014, Plaintiffs filed a notice of appeal to the United States Court of Appeals for the Third Circuit. Indemnity filed a motion to dismiss the appeal on March 26, 2014. On November 17, 2014, the Third Circuit deferred ruling on Indemnity’s motion to dismiss the appeal and instructed the parties to address that motion, as well as the merits of Plaintiffs’ appeal, in the parties’ briefing. Briefing was completed on April 2, 2015. In light of the Department’s April 29, 2015 decision in Sullivan, the Parties then jointly requested that the Beltz appeal be voluntarily dismissed as moot on June 5, 2015. The Third Circuit did not rule on the Parties’ request for dismissal and instead held oral argument as scheduled on June 8, 2015. On July 16, 2015, the Third Circuit issued an opinion and judgment dismissing the appeal. The Third Circuit found that it lacked appellate jurisdiction over the appeal, because the District Court’s February 10, 2014 order referring the matter to the Department was not a final, appealable order.

On July 8, 2016, the Beltz plaintiffs filed a new action labeled as a “Verified Derivative And Class Action Complaint” in the United States District Court for the Western District of Pennsylvania. The action is captioned Patricia R. Beltz, Joseph S. Sullivan, and Anita Sullivan, individually and on behalf of all others similarly situated, and derivatively on behalf of Nominal Defendant Erie Insurance Exchange v. Erie Indemnity Company; Kaj Ahlmann; John T. Baily; Samuel P. Black, III; J. Ralph Borneman, Jr.; Terrence W. Cavanaugh; Wilson C. Cooney; LuAnn Datesh; Patricia A. Goldman; Jonathan Hirt Hagen; Thomas B. Hagen; C. Scott Hartz; Samuel P. Katz; Gwendolyn King; Claude C. Lilly, III; Martin J. Lippert; George R. Lucore; Jeffrey A. Ludrof; Edmund J. Mehl; Henry N. Nassau; Thomas W. Palmer; Martin P. Sheffield; Seth E. Schofield; Richard L. Stover; Jan R. Van Gorder; Elizabeth A. Hirt Vorsheck; Harry H. Weil; and Robert C. Wilburn (the “Beltz II” lawsuit). The individual defendants are all present or former Directors of Indemnity (the “Directors”).

The allegations of the Beltz II lawsuit arise from the same fundamental, underlying claims as the Sullivan and prior Beltz litigation, i.e., that Indemnity improperly retained Service Charges and Added Service Charges. The Beltz II lawsuit alleges that the retention of the Service Charges and Added Service Charges was improper because, for among other reasons, that retention constituted a breach of the Subscriber’s Agreement and an Implied Covenant of Good Faith and Fair Dealing by Indemnity, breaches of fiduciary duty by Indemnity and the other defendants, conversion by Indemnity, and unjust enrichment by defendants Jonathan Hirt Hagen, Thomas B. Hagen, Elizabeth A. Hirt Vorsheck, and Samuel P. Black, III, at the expense of Exchange. The Beltz II lawsuit requests, among other things, that a judgment be entered against the Defendants certifying the action as a class action pursuant to Rule 23 of the Federal Rules of Civil Procedure; declaring Plaintiffs as representatives of the Class and Plaintiffs’ counsel as counsel for the Class; declaring the conduct alleged as unlawful, including, but not limited to, Defendants’ retention of the Service Charges and Added Service Charges; enjoining Defendants from continuing to retain the Service Charges and Added Service Charges; and awarding compensatory and punitive damages and interest.

On September 23, 2016, Indemnity filed a motion to dismiss the Beltz II lawsuit. On September 30, 2016, the Directors filed their own motions to dismiss the Beltz II lawsuit. The motions to dismiss remain pending.

Indemnity believes it has meritorious legal and factual defenses and intends to vigorously defend against all allegations and requests for relief in the Beltz II lawsuit. The Directors have advised Indemnity that they intend to vigorously defend against

36

the claims in the Beltz II lawsuit and have sought indemnification and advancement of expenses from the Company in connection with the Beltz II lawsuit.

For additional information on contingencies, see Part I, Item 1. "Financial Statements - Note 13, Commitments and Contingencies, of Notes to Financial Statements".


ITEM 1A.
RISK FACTORS
 
There have been no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2016 as filed with the Securities and Exchange Commission on February 23, 2017.


ITEM 2.
UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
 
Issuer Purchases of Equity Securities
In October 2011, our Board of Directors approved a continuation of the current stock repurchase program, authorizing repurchases for a total of $150 million with no time limitation.  This repurchase authority included, and was not in addition to, any unspent amounts remaining under the prior authorization. There were no repurchases of our Class A common stock under this program during the quarter ending March 31, 2017. We had approximately $17.8 million of repurchase authority remaining under this program at March 31, 2017.

During the quarter ending March 31, 2017, we purchased 3,785 shares of our outstanding Class A nonvoting common stock outside of our publicly announced share repurchase program at a total cost of $0.4 million, or $111.55 per share, for stock-based awards in conjunction with our equity compensation plan. These shares were delivered to plan participants in January 2017. In addition, we purchased 2,662 shares of our outstanding Class A nonvoting common stock outside of our publicly announced share repurchase program at a total cost of $0.3 million, or $118.69 per share, to fund the rabbi trust for the outside director deferred compensation plan. These shares were transferred to the rabbi trust in March 2017.


37

ITEM 6.
EXHIBITS

Exhibit
 
 
Number
 
Description of Exhibit
 
 
 
10.1*
 
Lease Agreement between Erie Insurance Exchange and Erie Indemnity Company effective January 1, 2017.
 
 
 
31.1*
 
Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
 
 
31.2*
 
Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
 
 
32*
 
Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 
 
101.INS*
 
XBRL Instance Document.
 
 
 
101.SCH*
 
XBRL Taxonomy Extension Schema Document.
 
 
 
101.CAL*
 
XBRL Taxonomy Extension Calculation Linkbase Document.
 
 
 
101.DEF*
 
XBRL Taxonomy Extension Definition Linkbase Document.
 
 
 
101.LAB*
 
XBRL Taxonomy Extension Label Linkbase Document.
 
 
 
101.PRE*
 
XBRL Taxonomy Extension Presentation Linkbase Document.

* Filed herewith.


38

SIGNATURES
 
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
 
 
Erie Indemnity Company
 
 
 
 
(Registrant)
 
 
 
 
 
 
 
 
 
 
 
Date:
May 1, 2017
By:
/s/ Timothy G. NeCastro
 
 
 
 
Timothy G. NeCastro, President & CEO
 
 
 
 
 
 
 
 
By:
/s/ Gregory J. Gutting
 
 
 
 
Gregory J. Gutting, Executive Vice President & CFO
 

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