The Erie Insurance Group also operates 24 field offices in 11 states. Of these field offices, 16 provide both agency support and claims services and are referred to as branch offices, while seven provide only claims services and are referred to as claims offices, and one provides only agency support and is referred to as a sales office. Eight field offices are owned by the Erie Insurance Group, while the remaining 16 field offices and one warehouse facility are leased from unaffiliated parties.
The following discussion of financial condition and results of operations highlights significant factors influencing the Erie Insurance Group (“we,” “us,” “our”). This discussion should be read in conjunction with the audited financial statements and related notes and all other items contained within this Annual Report on Form 10-K as they contain important information helpful in evaluating our financial condition and results of operations.
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, agency relationships, 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:
the Exchange’s ability to acquire reinsurance coverage and collectability from reinsurers;
The Erie Insurance Group represents the consolidated results of Indemnity and the results of its variable interest entity, the Exchange. The Erie Insurance Group operates predominantly as a property and casualty insurer through its regional insurance carriers that write a broad range of personal and commercial coverages. Our property and casualty insurance companies include the Exchange and its wholly owned subsidiaries, Erie Insurance Company (“EIC”), Erie Insurance Company of New York (“ENY”), Erie Insurance Property and Casualty Company (“EPC”) and Flagship City Insurance Company (“Flagship”). These entities operate collectively as the “Property and Casualty Group.” The Erie Insurance Group also operates as a life insurer through the Exchange’s wholly owned subsidiary, Erie Family Life Insurance Company (“EFL”), which underwrites and sells individual and group life insurance policies and fixed annuities(1).
a 0% equity interest in the net earnings of EFL after March 31, 2011 (the interest was 21.6% prior to March 31, 2011)(1);
a 100% interest in the net underwriting results of the property and casualty insurance operations;
a 100% interest in the net earnings of EFL after March 31, 2011 (the interest was 78.4% prior to March 31, 2011)(1);
Net income in 2013 benefited from improved results in our investment and property and casualty insurance operations, compared to 2012 and 2011. Our investment operations improved primarily due to an increase in net realized gains on investments compared to 2012, and compared to losses in 2011. The Exchange’s property and casualty insurance operations experienced a 9.0% increase in earned premium compared to 2012, driven by increases in policies in force and the average premium per policy, which also positively impacted Indemnity’s management fee revenue. The Exchange's 2013 property and casualty insurance operation's results were also positively impacted by lower levels of catastrophe losses, offset somewhat by lower levels of favorable development on prior accident year loss reserves, compared to 2012 and 2011.
Net income attributable to Indemnity Class A per share-diluted was $3.08 per share in 2013, compared to $2.99 per share in 2012, and $3.08 per share in 2011. The net income for 2011 included $0.02 per share-diluted related to the life insurance operations sold to the Exchange.
Operating income attributable to Indemnity Class A per share-diluted (excluding net realized gains or losses, impairments on investments, and related taxes) was $3.07 per share in 2013, compared to $2.92 in 2012, and $3.04 in 2011. The 2011 operating income amount included $0.02 per share-diluted related to the life insurance operations sold to the Exchange.
Our reportable segments include management operations, property and casualty insurance operations, life insurance operations, and investment operations.
EFL generates revenues through the sale of its individual and group life insurance policies and fixed annuities. These products provide our property and casualty agency force an opportunity to cross-sell both personal and commercial accounts. EFL’s profitability depends principally on the ability to develop, price, and distribute insurance products, attract and retain deposit funds, generate investment returns, and manage expenses. Other drivers include mortality and morbidity experience, persistency experience to enable the recovery of acquisition costs, maintenance of interest spreads over the amounts credited to deposit funds, and the maintenance of strong ratings from rating agencies. EFL plans to expand operations into the Commonwealth of Kentucky by the first quarter of 2015 or earlier if possible.
Our loss and loss expense reserves include amounts related to short-tail and long-tail lines of business. Tail refers to the time period between the occurrence of a loss and the final settlement of the claim. The longer the time span between the incidence of a loss and the settlement of the claim, the more the ultimate settlement amount can vary. Most of our loss and loss expense reserves relate to long-tail liability lines of business including workers compensation, bodily injury and other liability coverages, such as commercial liability. Short-tail lines of business, which represent a smaller percentage of our loss reserves, include personal auto physical damage and personal property.
Incurred development - Incurred loss development patterns (reflecting cumulative paid losses plus current case reserves) are generated from historical data. The patterns are applied to current incurred losses to generate estimated ultimate losses. Incurred methods and/or combinations of the paid and incurred methods are used in developing estimated ultimate losses for short-tail coverages and long-tail coverages,
Workers compensation and long-tailed liability (such as commercial liability) - We generally rely upon the expected loss ratio, Bornhuetter-Ferguson and incurred development techniques. These techniques are generally weighted together, relying more heavily on the Bornhuetter-Ferguson method at early ages of development and more on the incurred development method as the accident periods mature.
The accuracy of the various methods used to estimate reserves is a function of the degree to which underlying assumptions are satisfied. The most significant key assumptions are:
Future cost increase assumptions are derived from a review of historical cost increases and are assumed to persist into the future. Future medical cost increases and claimant mortality assumptions utilized in the reserve estimates for massive injury lifetime medical claims are obtained from industry studies adjusted for our own experience. Reserve levels are sensitive to these assumptions because they represent projections over 30 to 40 years into the future.
Auto no-fault (massive injury lifetime medical claims) - The automobile massive injury reserve carried by the Property and Casualty Group totaled $345 million at December 31, 2013, compared to $351 million at December 31, 2012. The slight decrease in the pre-1986 automobile massive injury reserves in 2013, compared to 2012, was primarily due to the the settlement of two claims. A 100-basis point increase in the medical cost inflation assumption would result in an increase in the Property and Casualty Group’s liability of $42 million at December 31, 2013.
Workers compensation (massive injury lifetime medical claims) - The workers compensation massive injury reserve carried by the Property and Casualty Group totaled $94 million at December 31, 2013, compared to $99 million at December 31, 2012. The slight decrease in the workers compensation massive injury reserves in 2013, compared to 2012, was primarily due to the settlement of one claim, offset somewhat by the addition of one new claim. The discount on these reserves was $23 million at December 31, 2013. A 100-basis point increase in the medical cost inflation assumption would result in an increase in the Property and Casualty Group’s liability of $15 million and an increase in the discount of $6 million at December 31, 2013.
Fair value measurements are based upon observable and unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect our view of market assumptions in the absence of observable market information. We utilize valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs.
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 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 benchmark yields, reported trades, issuer spreads, two-sided markets, benchmark securities, bids, offers, reference 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.
our intent to sell or more likely than not be required to sell (debt securities); and
The primary basis for the valuation of limited partnership interests is financial statements prepared by the general partner. Because of the timing of the preparation and delivery of these financial statements, the use of the most recently available
financial statements provided by the general partners generally result in a quarter delay in the inclusion of the limited partnership results in our Consolidated Statements of Operations. Due to this delay, these financial statements do not reflect the market conditions experienced in the fourth quarter of 2013.
Acquisition costs that vary with and relate to the production of life insurance and investment-type contracts are deferred. Deferred acquisition costs (“DAC”) are incremental direct costs of contract acquisition. As a result of new accounting guidance effective in 2012, these costs are limited to the successful acquisition of new and renewal contracts. Such costs consist principally of commissions and policy issuance expenses. The change does not affect the Indemnity shareholder interest nor does it affect Indemnity earnings per share. The amount of acquisition costs capitalized during 2012 related to life insurance and investment-type contracts totaled $17 million. The amount of acquisition costs that would have been capitalized during 2012 using the previous policy totaled $19 million. Prior to 2012, certain of these acquisition costs were deferred regardless of whether a contract was acquired.
charges. Both historical and anticipated investment returns, including realized gains and losses, are considered in determining the amortization of DAC. When the actual gross profits change from previously estimated gross profits, the cumulative DAC amortization is re-estimated and adjusted by a cumulative charge or credit to current operations. When actual gross profits exceed those previously estimated, DAC amortization will increase, resulting in a current period charge to earnings. The opposite result occurs when the actual gross profits are below the previously estimated gross profits. DAC is also adjusted for the impact of unrealized gains or losses on investments as if these gains or losses had been realized, with corresponding credits or charges, net of income taxes, included in EFL’s accumulated other comprehensive income, which is presented in the “Noncontrolling interest in consolidated entity - Exchange,” amount in the Consolidated Statements of Financial Position.
Deferred tax assets represent the tax benefit of future deductible temporary differences and operating loss and tax credit carry-forwards. Deferred tax assets are measured using the enacted tax rates expected to be in effect when such benefits are realized. We perform an analysis of our deferred tax assets to determine recoverability on a quarterly basis for each legal entity, by character of the income (ordinary or capital). Deferred tax assets are reduced by a valuation allowance, if based upon the weight of available evidence, it is more likely than not that some portion, or all, of the deferred tax assets will not be realized. In determining the need for a valuation allowance, we consider carry-back capacity, reversal of existing temporary differences, future taxable income and tax planning strategies. The determination of the valuation allowance for our deferred tax assets requires management to make certain judgments and assumptions regarding future operations that are based upon our historical experience and our expectations of future performance. Our judgments and assumptions are subject to change given the inherent uncertainty in predicting future performance, which is impacted by such things as financial market conditions, policyholder behavior, competitor pricing, new product introductions, and specific industry and economic conditions.
Indemnity had a net deferred tax asset of $2 million and $37 million at December 31, 2013 and 2012, respectively. There was no valuation allowance recorded on Indemnity at December 31, 2013 or 2012. The Exchange had a net deferred tax liability of $450 million and $365 million at December 31, 2013 and 2012, respectively.
The actuarial assumptions we used in determining our pension obligation may differ materially from actual results due to changing market and economic conditions, higher or lower withdrawal rates, or longer or shorter life spans of participants. While we believe that the assumptions used are appropriate, differences in actual experience or changes in assumptions may materially affect our financial position, results of operations, or cash flows.
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.
In 2012, compared to 2011, non-commission expense increased $42 million. Information technology costs increased $14 million, which included $4 million of personnel costs, $8 million of software, hardware, and maintenance costs, and $2 million of professional fees. Underwriting and policy processing costs increased $12 million driven by the 13.4% increase in new policies written. Sales and advertising costs increased $8 million, driven by a $4 million increase in both personnel and advertising and marketing costs. Customer service costs increased $4 million due to a $3 million increase in personnel costs and a $1 million increase in credit card processing fees. Administrative and other costs increased $4 million driven by increases in personnel costs. Personnel costs in all expense categories where impacted by higher staffing levels, increased pension and medical costs, and increased estimates for annual incentive plan compensation costs related to growth and underwriting performance.
The Property and Casualty Group operates in 11 Midwestern, Mid-Atlantic, and Southeastern states and the District of Columbia and primarily writes private passenger automobile, homeowners, commercial multi-peril, commercial automobile, and workers compensation lines of insurance. A summary of the results of our property and casualty insurance operations is as follows:
New business premiums written on personal lines increased 21.1% in 2013, compared to 20.9% in 2012, driven by increases in new business policies written and average premium per policy. Personal lines new business policies written increased 15.7% in 2013, compared to 15.1% in 2012, while the year-over-year average premium per policy on personal lines new business increased 4.7% at December 31, 2013, compared to 5.1% at December 31, 2012.
Homeowners new business premiums written increased 18.4% in 2013, compared to 30.4% in 2012. New business policies written for homeowners increased 11.7% in 2013, compared to 18.8% in 2012. The new business year-over-year average premium per policy for homeowners increased 6.0% at December 31, 2013, compared to 9.8% at December 31, 2012.
Private passenger auto renewal premiums written increased 4.5% in 2013, compared to 3.2% in 2012. The year-over-year average premium per policy on private passenger auto renewal business increased 1.5% at December 31, 2013, compared to 1.1% at December 31, 2012. The private passenger auto year-over-year policy retention ratio was 92.1% at December 31, 2013 and 2012, and 91.6% at December 31, 2011.
Homeowners renewal premiums written increased 12.2% in 2013, compared to 11.5% in 2012. The year-over-year average premium per policy on homeowners renewal business increased 8.4% at December 31, 2013, compared to 8.7% in 2012. The homeowners year-over-year policyholder retention ratio was 90.1% at December 31, 2013, 90.9% at December 31, 2012, and 91.0% at December 31, 2011.
Commercial lines - Total commercial lines premiums written increased 11.8%, to $1.5 billion in 2013, from $1.3 billion in 2012, driven by a 5.2% increase in total commercial lines policies in force and a 6.3% increase in the total commercial lines year-over-year average premium per policy.
New business premiums written on commercial lines increased 6.3% in 2013, compared to 24.5% in 2012, driven by increases in new business policies written and average premium per policy. The combined impact of these increases was seen primarily in the commercial multi-peril and commercial auto lines of business. Commercial lines new business policies written increased 4.6% in 2013, compared to 6.5% in 2012, while the year-over-year average premium per policy on commercial lines new business increased 1.6% at December 31, 2013, compared to 16.9% at December 31, 2012.
Future trends-premium revenue - We plan to continue our efforts to grow Property and Casualty Group premiums and improve our competitive position in the marketplace. Expanding the size of our 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 book of business with the Property and Casualty Group. At December 31, 2013, we had over 2,150 agencies with over 10,550 licensed property and casualty representatives. The Property and Casualty Group plans to expand operations into the Commonwealth of Kentucky by the first quarter of 2015 or earlier if possible.
Changes in premium levels attributable to rate changes also directly affect the profitability of the Property and Casualty Group and have a direct bearing on Indemnity’s management fee. Pricing actions contemplated or taken by the Property and Casualty Group are subject to various regulatory requirements of the states in which our insurers operate. The pricing actions already implemented, or to be implemented, have an effect on the market competitiveness of our insurance products. Such pricing actions, and those of competitors, could affect the ability of our agents to retain and attract new business. We expect the Property and Casualty Group’s pricing actions to result in a net increase in direct written premium in 2014, however, exposure reductions and/or changes in our mix of business as a result of economic conditions could impact the average premium written by the Property and Casualty Group, as customers may reduce coverages.
Current accident year, excluding catastrophe losses - The current accident year loss and loss expense ratio for all lines of business, excluding catastrophe losses, was 66.8% in 2013, compared to 68.1% in 2012 and 68.6% in 2011. The personal lines loss and loss expense ratio related to the current accident year, excluding catastrophe losses, was 67.3% in 2013, compared to 68.5% in 2012 and 69.4% in 2011. The commercial lines loss and loss expense ratio related to the current accident year, excluding catastrophe losses, was 65.7% in 2013, compared to 67.1% in 2012 and 66.6% in 2011.
Current accident year catastrophe losses - Catastrophic events, destructive weather patterns, or changes in climate conditions are an inherent risk of the property and casualty insurance business and can have a material impact on our property and casualty insurance underwriting results. In addressing this risk, we employ what we believe are reasonable underwriting standards and monitor our exposure by geographic region. The Property and Casualty Group’s definition of catastrophes includes those weather-related or other loss events that we consider significant to our geographic footprint which, individually or in the aggregate, may not reach the level of a national catastrophe as defined by the Property Claim Service ("PCS").
The Property and Casualty Group maintains property catastrophe reinsurance coverage from unaffiliated reinsurers to mitigate future potential catastrophe loss exposures and no longer participates in the voluntary assumed reinsurance business, which lowers the variability of the Property and Casualty Group’s underwriting results. The property catastrophe reinsurance coverage during 2013 included a first treaty that provided coverage of up to 90% of a loss of $550 million in excess of the Property and Casualty Group’s loss retention of $350 million per occurrence, a second treaty that provided coverage of up to 70% of a loss of $225 million in excess of $900 million, and a third treaty that provided coverage of up to 70% of a loss of $25 million in excess of $1.125 billion. The property catastrophe reinsurance coverage that became effective for January 1, 2014 included a first property catastrophe reinsurance treaty providing coverage of up to 30% of a loss of $100 million in excess of the Property and Casualty Group’s loss retention of $300 million per occurrence, a second treaty providing coverage of up to 90% of a loss of $500 million in excess of $400 million, a third treaty providing coverage of up to 85% of a loss of $200 million in excess of $900 million, and a fourth treaty providing coverage of up to 100% of a loss of $25 million in excess of $1.1 billion.
While the Property and Casualty Group is exposed to terrorism losses in commercial lines, including workers compensation, these lines are afforded a limited backstop above insurer deductibles for foreign acts of terrorism under the federal Terrorism Risk Insurance Program Reauthorization and Extension Act of 2007 that continues through December 31, 2014. There is no
Catastrophe losses for the current accident year, as defined by the Property and Casualty Group, totaled $162 million in 2013, $489 million in 2012, and $773 million in 2011, and contributed 3.4 points, 11.0 points and 18.6 points to the respective loss ratios.
Favorable development of $22 million related to the personal auto line of business resulting from better than expected severity trends, offset somewhat by minor changes across all other lines of business, which impacted the 2012 accident year.
Assumed reinsurance - The Property and Casualty Group experienced favorable development on prior accident year loss reserves for its assumed involuntary reinsurance business totaling $13 million in 2013, compared to $14 million in 2012, and $22 million in 2011. The favorable development in 2013, 2012 and 2011 was due to less than anticipated growth in involuntary reinsurance.
Policy acquisition and other underwriting expenses - Our policy acquisition and other underwriting expense ratio decreased 0.3% points to 28.8% in 2013, from 29.1% in 2012, and increased 0.7 points in 2012 from 28.4% in 2011. The 2012 policy acquisition and other underwriting expenses include a charge related to the adoption, on a prospective basis, of the new accounting guidance effective in 2012 related to the lower level of policy acquisition expenses eligible to be deferred. Additionally, 2012 included an adjustment of $4 million which contributed 0.1 points to the combined ratio at December 31, 2012. This adjustment represents the reimbursement by the North Carolina Reinsurance Facility (NCRF) for commissions Indemnity paid to agents on the surcharges collected on behalf of the NCRF which was incorrectly recorded as a benefit to the Exchange in prior periods. The management fee rate was 25.0% in 2013, 2012 and 2011.
Gross policy revenues increased 4.6% to $121 million in 2013, compared to $116 million in 2012, and $110 million in 2011. EFL uses, and has used, a variety of reinsurance programs to reduce claims volatility and for other financial benefits. While the amount of risk that EFL retains can vary based upon the type of policy issued and the year it was issued, EFL generally does not retain more than $1 million of risk on any individual life. Ceded reinsurance premiums totaled $41 million in 2013, and $43 million in both 2012 and 2011.
Annuity and universal life premiums that are recorded as deposits totaled $59 million, $58 million, and $68 million in 2013, 2012 and 2011, respectively, and therefore are not reflected in individual and group life premiums in the table above.
EFL’s investment revenue increased in 2013 due to net realized gains on investments from the sale of bonds and a slight increase in equity in earnings of limited partnerships. Offsetting these increases was a slight decrease in net investment income due to lower investment yields and a slight increase in impairment losses recognized in earnings due to four bond impairments. In 2012, EFL’s investment revenue experienced a decrease in net realized gains on investments, as 2011 had gains related to the sale of preferred stock securities, and a decrease in equity in earnings of limited partnerships due to a decline in real estate investments. Offsetting these decreases was a slight increase in net investment income and low levels of impairments. See the discussion of investments in the “Investment Operations” segment that follows for further information.
The Exchange’s investment results include net investment revenues from EFL’s operations of $111 million in 2013, $104 million in 2012, and $109 million in 2011.
Net investment income primarily includes interest and dividends on our fixed maturity and equity security portfolios.
Indemnity's net investment income decreased by $1 million in 2013, compared to 2012, and was unchanged in 2012, compared to 2011, while net investment income for the Exchange decreased by $14 million and increased by $5 million during the same respective periods. The decrease in net investment income for Indemnity in 2013 was primarily due to lower average invested balances, while the decrease for the Exchange was due to lower average yields partially offset by an increase in invested balances. The increase in net investment income for the Exchange in 2012 was primarily due to higher invested balances and higher dividend income from equity securities which more than offset a decrease in income from fixed maturities due to lower reinvestment yields.
Indemnity generated net realized gains of $1 million in 2013, compared to gains of $5 million in 2012, and gains of $3 million in 2011. The Exchange generated net realized gains of $770 million in 2013, compared to gains of $413 million in 2012, and losses of $7 million in 2011. Realized gains for Indemnity in 2013 were primarily attributable to gains from sales of fixed maturity securities. Indemnity recorded no changes in the fair value of common stocks in 2013 due to the sale of its common stock portfolio classified as trading securities in the fourth quarter of 2012. In 2012, Indemnity's net realized gains were primarily due to the favorable performance and sale of its common stock portfolio. Realized gains for the Exchange in both 2013 and 2012 were primarily due to increases in fair value and realized gains on the sale of common stock securities reflecting favorable market performance. In 2011, Indemnity recorded $6 million of realized gains on the sale of securities which was offset by decreases in fair value of $3 million on its common stock portfolio, while the Exchange recorded $240 million of realized gains on the sale of securities which was offset by decreases in fair value of $247 million on its common stock portfolio.
Net impairment losses recognized in earnings for Indemnity were $0.4 million in 2013, compared to $0.1 million in 2012, and no impairments in 2011. Impairment losses for the Exchange totaled $13 million in 2013, compared to $0.1 million in 2012, and $2 million in 2011. The increase in impairments for the Exchange in 2013 was primarily due to several fixed maturity securities and one equity security in unrealized loss positions that we intend to sell prior to an expected recovery of fair value to cost.
The Exchange’s results include net realized gains from EFL’s operations of $17 million in 2013, $9 million in 2012, and $13 million in 2011.
(2) Structured securities include asset-backed securities, collateral, lease and debt obligations, commercial mortgage-backed securities, and residential mortgage-backed securities.
The following table presents an analysis of the fair value of our preferred and common stock securities by sector for Indemnity and the Exchange, respectively:
Our common stocks classified as trading securities are measured at fair value with all changes in unrealized gains and losses reflected in the Consolidated Statements of Operations.
In 2013, investments in limited partnerships decreased for Indemnity from the investment levels at December 31, 2012, while the decrease for the Exchange during the same period was less significant. 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 due to net distributions received from the partnerships which were partially offset by increases in underlying asset values. Indemnity has made no new limited partnership commitments since 2006, and the balance of its 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 at December 31, 2013 reflect the partnership activity experienced during the twelve month period ending September 30, 2013.
Loss reserves are established to account for the estimated ultimate costs of losses and loss expenses for claims that have been reported but not yet settled and claims that have been incurred but not reported. While we exercise professional diligence to establish reserves at the end of each period that are fully reflective of the ultimate value of all claims incurred, these reserves are, by their nature, only estimates and cannot be established with absolute certainty. The factors which may potentially cause the greatest variation between current reserve estimates and the actual future paid amounts include unforeseen changes in statutory or case law altering the amounts to be paid on existing claim obligations, new medical procedures and/or drugs with costs significantly different from those seen in the past, inflation, and claims patterns on current business that differ significantly from historical claims patterns.
The reserves that have the greatest potential for variation are the massive injury lifetime medical claim reserves. The Property and Casualty Group is currently reserving for 251 claimants requiring lifetime medical care, of which 95 involve massive injuries. The reserve carried by the Property and Casualty Group for the massive injury claimants, which includes automobile massive injury and workers compensation massive injury reserves, totaled $291 million at December 31, 2013, which is net of $148 million of anticipated reinsurance recoverables, compared to $305 million at December 31, 2012, which was net of $145 million of anticipated reinsurance recoverables. The pre-1986 automobile and workers compensation massive injury gross
Property and casualty insurance premiums are established before losses occur and before loss expenses are incurred, and therefore, before the extent to which inflation may impact such costs is known. Consequently, in establishing premium rates, we attempt to anticipate the potential impact of inflation, including medical cost inflation, construction and auto repair cost inflation, and tort issues. Medical costs are a broad element of inflation that impacts personal and commercial auto, general liability, workers compensation, and commercial multi-peril lines of insurance written by the Property and Casualty Group. Inflation assumptions take the form of explicit numerical values in the survival ratio, individual claim, and massive injury lifetime medical reserving methods. Inflation assumptions are implicitly derived through the selection of applicable loss development patterns for all other reserving methods. Occasionally, unusual aberrations in loss development patterns are caused by external and internal factors such as changes in claim reporting, settlement patterns, unusually large losses, process changes, legal or regulatory changes, and other influences. In these instances, analyses of alternate development factor selections are performed to evaluate the effect of these factors and actuarial judgment is applied to make appropriate assumptions needed to develop a best estimate of ultimate losses.
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 impair 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 other sources even if financial market volatility persists throughout 2014.
At December 31, 2013, we recorded a net deferred tax asset of $2 million related to Indemnity and a net deferred tax liability of $450 million related to the Exchange. There was no valuation allowance at December 31, 2013. During calendar years 2013, 2012, and 2011, we received cash refunds of federal income taxes paid in prior tax periods of $4 million, $49 million, and $9 million respectively.
Net cash used in investing activities totaled $759 million in 2013, $85 million in 2012, and $375 million in 2011. Investing activities in 2013 primarily included an increase in certain fixed maturity purchases and decreased cash generated from the sale of common stocks, offset somewhat by a decrease in other common stock purchases, compared to 2012. At December 31, 2013, we had contractual commitments to invest up to $438 million related to our limited partnership investments to 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 $166 million, mezzanine debt securities was $169 million, and real estate activities was $103 million. In 2012, cash used in investing activities decreased compared to 2011, due to increased cash generated from the sale of fixed maturities, offset somewhat by an increase in other fixed maturity purchases.
Net cash provided by Indemnity’s operating activities increased to $218 million in 2013, compared to $205 million in 2012, and $169 million in 2011. Increased cash from operating activities in 2013 was primarily due to increases in management fee revenue and limited partnership distributions received. Offsetting this increase in cash were increases in cash paid for commissions to agents, general operating expenses, salaries and wages, and income taxes, combined with a slight decrease in net investment income received, compared to 2012. Management fee revenues were higher reflecting the increase in premiums written or assumed by the Exchange. Cash paid for agent commissions and bonuses increased to $681 million in 2013, compared to $617 million in 2012, as a result of an increase in cash paid for scheduled commissions and bonus awards. Indemnity made a $17 million contribution to its pension plan in 2013, compared to $16 million in 2012. Additionally, Indemnity will make a contribution to its pension plan for $15 million in the first quarter of 2014. Indemnity’s policy for funding its pension plan is generally to contribute an amount equal to the greater of the IRS minimum required contribution or the target normal cost for the year plus interest to the date the contribution is made. Indemnity is generally reimbursed approximately 56% of the net periodic benefit cost of the pension plan from its affiliates, which represents pension benefits for Indemnity employees performing claims and EFL functions. In 2012, increased cash from operating activities, compared to 2011, was primarily due to increases in management fee revenue and net investment income received, offset somewhat by increases in commissions paid to agents, general operating expenses paid, and cash paid for salaries and wages.
In the first quarter of 2011, Indemnity received cash consideration from the Exchange of $82 million as a result of the sale of Indemnity’s 21.6% ownership interest in EFL to the Exchange on March 31, 2011, which was based upon an estimated purchase price. Final settlement of this transaction was made on April 25, 2011 for a final purchase price of $82 million. Net after-tax cash proceeds to Indemnity from this sale were $58 million. Also in the first quarter of 2011, on March 18, Indemnity paid $8 million to the Exchange as final settlement of the sale of Indemnity’s wholly owned property and casualty insurance subsidiaries, EIC, ENY and EPC, to the Exchange on December 31, 2010, which was based upon the final purchase price.
Indemnity repurchased 441,024 shares of its Class A nonvoting common stock in conjunction with its stock repurchase program at a total cost of $31.9 million in 2013, based upon settlement date. In 2012, shares repurchased under this program
totaled 986,439 at a total cost of $70.2 million, compared to 2,200,085 shares at a total cost of $154.9 million in 2011. 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. This repurchase authority includes, and is not in addition to, any unspent amounts remaining under the prior authorization. Indemnity had approximately $37 million of repurchase authority remaining under this program at December 31, 2013, based upon trade date.
In 2013, we repurchased 3,477 shares of our outstanding Class A nonvoting common stock outside of our publicly announced share repurchase program at a total cost of $255,454 to settle payments due to a retired executive under our long-term incentive plan. These shares were delivered to the plan participant in January 2013 and June 2013. In 2012, we also repurchased 1,803 shares of our outstanding Class A nonvoting common stock outside of our publicly announced share repurchase program at a total cost of $129,849 to settle payments due to two retired senior vice presidents under our long-term incentive plan. These shares were delivered to the plan participants in January 2012 and June 2012, respectively. In 2011, we repurchased 64,095 shares of our outstanding Class A nonvoting common stock outside of our publicly announced share repurchase program at a total cost of $5 million in conjunction with our long-term incentive plan and for the vesting of stock-based awards for executive management. These shares were delivered to plan participants and executive management, respectively, in July 2011.
Outside of Indemnity’s normal operating and investing cash activities, future funding requirements could be met through: 1) Indemnity’s cash and cash equivalents, which total approximately $49 million at December 31, 2013, 2) a $100 million bank revolving line of credit held by Indemnity, and 3) liquidation of assets held in Indemnity’s investment portfolio, including common stock, preferred stock, and investment grade bonds which totaled approximately $464 million at December 31, 2013. Volatility in the financial markets could impair Indemnity’s ability to sell certain of its fixed income securities or cause such securities to sell at deep discounts. Additionally, Indemnity has the ability to curtail or modify discretionary cash outlays such as those related to shareholder dividends and share repurchase activities.
On October 25, 2013, Indemnity amended its revolving credit facility to extend the maturity date, lower the borrowing costs, and eliminate the minimum net worth financial covenant. As of December 31, 2013, Indemnity has access to a $100 million bank revolving line of credit with a $25 million letter of credit sublimit that expires on November 3, 2018. As of December 31, 2013, a total of $98.2 million remains available under the facility due to $1.8 million outstanding letters of credit, which reduce the availability for letters of credit to $23.2 million. Indemnity had no borrowings outstanding on its line of credit as of December 31, 2013. Bonds with a fair value of $111 million were pledged as collateral on the line at December 31, 2013. These securities have no trading restrictions. The bank requires compliance with certain covenants, which include leverage ratios. Indemnity was in compliance with its bank covenants at December 31, 2013.
Outside of the Exchange’s normal operating and investing cash activities, future funding requirements could be met through: 1) the Exchange’s cash and cash equivalents, which total approximately $403 million at December 31, 2013, 2) a $300 million bank revolving line of credit held by the Exchange, and 3) liquidation of assets held in the Exchange’s investment portfolio, including common stock, preferred stock, and investment grade bonds which totaled approximately $11.6 billion at December 31, 2013. Volatility in the financial markets could impair the Exchange’s ability to sell certain of its fixed income securities or cause such securities to sell at deep discounts.
On October 25, 2013, the Exchange entered into a second amended and restated credit agreement to extend the maturity date, lower the borrowing costs, and eliminate the minimum statutory surplus covenant. As of December 31, 2013, the Exchange has access to a $300 million bank revolving line of credit with a $25 million letter of credit sublimit that expires on October 25, 2018. As of December 31, 2013, a total of $298.9 million remains available under the facility due to $1.1 million outstanding letters of credit, which reduce the availability for letters of credit to $23.9 million. The Exchange had no borrowings outstanding on its line of credit as of December 31, 2013. Bonds with a fair value of $332 million were pledged as collateral on the line at December 31, 2013. These securities have no trading restrictions. The bank requires compliance with certain covenants, which include statutory surplus and risk based capital ratios. The Exchange was in compliance with its bank covenants at December 31, 2013.
Indemnity has no rights to the assets, capital, or line of credit of the Exchange and, conversely, the Exchange has no rights to the assets, capital, or line of credit of Indemnity. We believe we have the funding sources available to us to support our cash flow requirements in 2014.
Cash outflows for the Property and Casualty Group are variable as fluctuations in settlement dates for claims payments vary and cannot be predicted with absolute certainty. While volatility in claims payments could be significant, the cash flow requirements for claims have not historically had a significant effect on our liquidity. Based upon a historical 15 year average, approximately 30% of losses and loss expenses included in reserves for the Property and Casualty Group are settled within the first 12 months, and approximately 75% are settled within the first five years. Amounts that are paid after the first five years reflect long-tail lines such as workers compensation and auto bodily injury.
We have certain obligations and commitments to make future payments under various contracts. As of December 31, 2013, the aggregate obligations were as follows:
Operating leases - real estate are for 16 of our 24 field offices that are operated in the states in which the Property and Casualty Group does business and one operating lease is for a warehouse facility leased from unaffiliated parties.
The maximum dividend EFL could pay the Exchange in 2014 without prior approval is $29 million. No dividends were paid by EFL in 2013, 2012 or 2011.
The Exchange is operated for the interest of its subscribers (policyholders) and any distributions it might declare would only be payable to them. The Exchange did not make any distributions to its subscribers (policyholders) in 2013, 2012, or 2011.
effective manner and ensuring long term stability for policyholders as well as shareholders. Since risk is integral to our business, we strive to manage the multitude of risks we face in an optimal manner.
Indemnity serves as attorney-in-fact for the policyholders at the Exchange, a reciprocal insurance exchange. Each applicant for insurance to a reciprocal insurance exchange signs a subscriber’s agreement that contains an appointment of an attorney-in-fact. Through the designation of attorney-in-fact, Indemnity is required to provide sales, underwriting, and policy issuance services to the policyholders of the Exchange, as discussed previously. Pursuant to the subscriber’s agreement, Indemnity earns a management fee for these services calculated as a percentage of the direct premiums written by the Exchange and the other members of the Property and Casualty Group, which are assumed by the Exchange under an intercompany pooling arrangement.
Indemnity holds 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. Indemnity recognized interest income on the note of $2 million in both 2013 and 2012.
The Exchange holds a surplus note for $20 million from EFL that is payable on demand on or after December 31, 2025; 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. The Exchange recognized interest income on the note of $1 million in both 2013 and 2012.
Change in unrealized holding (losses) gains on available-for-sale securities, net of tax benefit (expense) of $125, $(121), and $(12), respectively
Class A common stock, stated value $0.0292 per share; 74,996,930 shares authorized; 68,299,200 shares issued; 46,461,125 and 46,892,681 shares outstanding, respectively
Dividends declared - Class B ($361.875, $637.50 and $314.625 per share, respectively)
Erie Indemnity Company (“Indemnity”) is a publicly held Pennsylvania business corporation that has been the managing attorney-in-fact for the subscribers (policyholders) at the Erie Insurance Exchange (“Exchange”) since 1925. The Exchange is a subscriber-owned, Pennsylvania-domiciled, reciprocal insurer that writes property and casualty insurance.
Erie Family Life Insurance Company (“EFL”) is an affiliated life insurance company that underwrites and sells individual and group life insurance policies and fixed annuities. On March 31, 2011, Indemnity sold its 21.6% ownership interest in EFL to the Exchange.
The accompanying consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles (“GAAP”) and include the accounts of Indemnity together with its affiliated companies in which Indemnity holds a majority voting or economic interest.
All intercompany assets, liabilities, revenues, and expenses between Indemnity and the Exchange have been eliminated in the Consolidated Financial Statements.
annual periods beginning after December 15, 2011. In December 2011, the FASB issued ASU 2011-12, Comprehensive Income - Deferral of The Effective Date for Amendments to the Presentation of Reclassification of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update 2011-5. The amendments in this ASU supersede changes to paragraphs in ASU 2011-5 that pertain to how, when and where reclassification adjustments are presented. We have elected to present total comprehensive income in two separate but consecutive statements. The disclosures required by this guidance have been included in the Consolidated Statements of Operations and the Consolidated Statements of Comprehensive Income.
In January 2014, the FASB issued ASU 2014-01, Accounting for Investments in Qualified Affordable Housing Projects. This guidance permits reporting entities to make an accounting policy election to account for their investments in qualified affordable housing projects using the proportional amortization method if certain conditions are met. Generally, investors in qualified affordable housing project investments expect to receive substantially all of their return through the receipt of tax credits and other tax benefits. ASU 2014-01 allows for the recording of the investment performance net of taxes as a component of income tax expense to more fairly represent the economics of the investments and provide users with a better understanding of the returns from such investments. The qualifications to make this accounting election were also made less restrictive. ASU 2014-01 is effective for annual and interim periods beginning after December 15, 2014, with early adoption permitted. While we are currently evaluating whether to make the accounting election and whether the election would be made for early adoption, such election is not expected to have a material impact on our consolidated financial statements.
short and long-term prospects of the issuer and its industry based upon analysts’ recommendations;
Because of the timing of the preparation and delivery of financial statements for limited partnership investments, the use of the most recently available financial statements provided by the general partners result in a quarter delay in the inclusion of the limited partnership results in our Consolidated Statements of Operations. Due to this delay, these financial statements do not yet reflect the market conditions experienced in the fourth quarter of 2013 for all partnerships other than the real estate limited partnerships that are reported under the fair value option.
Cash and cash equivalents - Short-term investments, consisting of cash, money market accounts and other short-term, highly liquid investments with a maturity of three months or less at the date of purchase, are considered cash and cash equivalents.
Deferred annuity future benefit reserves are established at accumulated account values without reduction for surrender charges. These account values are credited with varying interest rates determined at the discretion of EFL subject to certain minimums.
Indemnity earns management fees from the Exchange for providing sales, underwriting, and policy issuance services. Pursuant to the subscriber’s agreements with the policyholders at the Exchange, Indemnity may retain up to 25% of all premiums written or assumed by the Exchange. Management fee revenue is calculated by multiplying the management fee rate by the direct premiums written by the Exchange and the other members of the Property and Casualty Group, which are assumed by the Exchange under an intercompany pooling arrangement. The Property and Casualty Group issues policies with annual terms only. Management fees are recorded as revenue upon policy issuance or renewal, as substantially all of the services required to be performed by us have been satisfied at that time. Certain activities are performed and related costs are incurred by us subsequent to policy issuance in connection with the services provided to the Exchange; however, these activities are inconsequential and perfunctory. Management fee revenue is eliminated upon consolidation.
Consolidation of the Exchange’s financial results is required given the significance of the management fee to the Exchange and because Indemnity has the power to direct the activities of the Exchange that most significantly impact the Exchange’s economic performance. The Exchange’s anticipated economic performance is the product of its underwriting results combined with its investment results. The fees paid to Indemnity under the subscriber’s agreement impact the anticipated economic performance attributable to the Exchange’s results. Indemnity earns a management fee from the Exchange for the services it provides as attorney-in-fact. Indemnity’s management fee revenues are based upon all premiums written or assumed by the Exchange. Indemnity’s Board of Directors determines the management fee rate to be paid by the Exchange to Indemnity. This rate cannot exceed 25% of the direct and assumed written premiums of the Exchange, as defined by the subscriber’s agreement signed by each policyholder. Management fee revenues and management fee expenses are eliminated upon consolidation.
The shareholders of Indemnity have no rights to the assets of the Exchange and no obligations arising from the liabilities of the Exchange. Indemnity has no obligation related to any underwriting and/or investment losses experienced by the Exchange. Indemnity would, however, be adversely impacted if the Exchange incurred significant underwriting and/or investment losses. If the surplus of the Exchange were to decline significantly from its current level, its financial strength ratings could be reduced and, as a consequence, the Exchange could find it more difficult to retain its existing business and attract new business. A decline in the business of the Exchange would have an adverse effect on the amount of the management fees Indemnity receives. In addition, a decline in the surplus of the Exchange from its current level may impact the management fee rate received by Indemnity. Indemnity also has an exposure to a concentration of credit risk related to the unsecured receivables due from the Exchange for its management fee. If any of these events occurred, Indemnity’s financial position, financial performance, and/or cash flows could be adversely impacted.
On March 31, 2011, Indemnity sold its 21.6% ownership interest in EFL to the Exchange. All property and casualty and life insurance operations are owned by the Exchange, and Indemnity functions solely as the management company.
The following tables summarize the components of the Consolidated Statements of Operations by reportable business segment:
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.
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.
(1) Other investments measured at fair value represent four real estate funds included on the balance sheet as limited partnership investments that are reported under the fair value option. These 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 they represent the NAV 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 December 31, 2013. During the year ended December 31, 2013, Indemnity made no contributions and received distributions totaling $2.4 million, and the Exchange made no contributions and received distributions totaling $21.7 million for these investments. As of December 31, 2013, the amount of unfunded commitments related to the investments was $1.5 million for Indemnity and $4.5 million for the Exchange.
(1) These amounts are reported in the Consolidated Statements of Operations. There was $2 million included in net realized investment gains (losses) and $2 million included in equity in earnings of limited partnerships for the three months ended December 31, 2013 on Level 3 investments.
For Indemnity, there were no Level 1 to Level 2 transfers for the year ended December 31, 2013. Level 2 to Level 1 transfers totaled $1 million due to trading activity levels related to one preferred stock holding, and there were no transfers between Level 2 and Level 3.
For the Exchange, Level 1 to Level 2 transfers totaled $6 million and Level 2 to Level 1 transfers totaled $51 million due to trading activity levels related to one preferred stock holding and five preferred stock holdings, respectively, for the year ended December 31, 2013. Level 2 to Level 3 transfers totaled $39 million for seven fixed maturity holdings and one preferred stock holding, and Level 3 to Level 2 transfers totaled $47 million for six fixed maturity holdings. These transfers in and out of Level 3 were primarily the result of using non-binding and binding broker quotes, respectively to determine the fair value at December 31, 2013.
Corporate debt securities - The unobservable input used in the fair value measurement of certain corporate debt securities is the likelihood of repayment by the underlying entity when there is no market for trading these securities. When available, we obtain non-binding broker quotes to value such securities.
Corporate debt securities and Collateralized-debt-obligation securities - When a non-binding broker quote was the only input available, it was considered unobservable.
Other investments - Other investments represent certain limited partnerships that are recorded at fair value and are based upon net asset value (NAV) provided by the general partner where the unobservable inputs are not reasonably available to us.
The following table presents our consolidated fair value measurements on a recurring basis by asset class and level of input at December 31, 2012:
(1) These amounts are reported in the Consolidated Statements of Operations. There was $1 million included in net realized investment gains (losses) and $3 million included in equity in earnings of limited partnerships for the three months ended December 31, 2012 on Level 3 investments.
(2) Transfers in and out of Level 3 are attributable to changes in the availability of market observable information for individual investments within the respective categories. Transfers in and out of levels are recognized at the start of the period.
For Indemnity, Level 1 to Level 2 transfers totaled $4 million for the three months ended December 31, 2012. Trading activity levels for two preferred stock holdings necessitated reclassification between levels. There were no transfers from Level 2 to Level 1 or between Level 2 and Level 3.
(1) These amounts are reported in the Consolidated Statements of Operations. There was $3 million included in net realized investment gains (losses) and $13 million included in equity in earnings of limited partnerships for the year ended December 31, 2012 on Level 3 securities.
(2) Transfers in and out of Level 3 are attributable to changes in the availability of market observable information for individual investments within the respective categories. Transfers in and out of levels are recognized at the end of the period.
The following table summarizes the cost and fair value of our available-for-sale securities at December 31, 2013:
Available-for-sale securities in a gross unrealized loss position at December 31, 2013 are as follows. Data is provided by length of time for securities in a gross unrealized loss position.
Amounts included in equity in earnings of limited partnerships by method of accounting are included below:
We have provided summarized financial information in the following tables for the years ended December 31, 2013 and 2012. Amounts provided in the tables are presented using the latest available financial statements received from the partnerships for the respective periods. Limited partnership financial information has been presented based upon the investment percentage in the partnerships for the Erie Insurance Group consistent with how management evaluates these investments.
As these investments are generally reported on a one-quarter lag, our limited partnership results through December 31, 2012 include partnership financial results for the fourth quarter of 2011 and the first three quarters of 2012.
The following table outlines the estimated future amortization expense related to capitalized software development costs as of December 31, 2013:
On October 25, 2013, Indemnity amended its revolving credit facility to extend the maturity date, lower the borrowing costs, and eliminate the minimum net worth financial covenant. As of December 31, 2013, Indemnity has access to a $100 million bank revolving line of credit with a $25 million letter of credit sublimit that expires on November 3, 2018. As of December 31, 2013, a total of $98.2 million remains available under the facility due to $1.8 million outstanding letters of credit, which reduce the availability for letters of credit to $23.2 million. Indemnity had no borrowings outstanding on its line of credit as of December 31, 2013. Bonds with a fair value of $111 million were pledged as collateral on the line at December 31, 2013.
On October 25, 2013, the Exchange entered into a second amended and restated credit agreement to extend the maturity date, lower the borrowing costs, and eliminate the minimum statutory surplus covenant. As of December 31, 2013, the Exchange has access to a $300 million bank revolving line of credit with a $25 million letter of credit sublimit that expires on October 25, 2018. As of December 31, 2013, a total of $298.9 million remains available under the facility due to $1.1 million outstanding letters of credit, which reduce the availability for letters of credit to $23.9 million. The Exchange had no borrowings outstanding on its line of credit as of December 31, 2013. Bonds with a fair value of $332 million were pledged as collateral on the line at December 31, 2013.
Neither the Indemnity nor the Exchange had a valuation allowance recorded at December 31, 2013 or December 31, 2012.
Indemnity is the attorney-in-fact for the subscribers (policyholders) at the Exchange, a reciprocal insurance exchange. In that capacity, Indemnity provides all services and facilities necessary to conduct the Exchange’s insurance business. Indemnity and the Exchange together constitute a single insurance business. Indemnity is not subject to state corporate income or franchise taxes in states where the Exchange conducts its business and the states collect premium tax in lieu of corporate income or franchise tax, as a result of the Exchange’s remittance of premium taxes in those states.
Deferred policy acquisition costs asset, end of year - Property and Casualty Group
Loss reserves are set at full expected cost, except for workers compensation loss reserves, which have been discounted using an interest rate of 2.5% for all periods presented. This discounting reduced unpaid losses and loss expenses by $85 million, $85 million and $84 million at December 31, 2013, 2012 and 2011, respectively. The reserves for losses and loss expenses are reported net of receivables for salvage and subrogation, which totaled $149 million, $150 million and $145 million at December 31, 2013, 2012 and 2011, respectively.
Favorable development on prior accident year loss reserves was minimal in 2013. In 2012, the favorable development on prior accident year direct loss reserves was primarily the result of improved claims frequency and severity trends combined with the closing of several large claims in our homeowners, commercial multi-peril, and commercial auto lines of business, offset somewhat by adverse development in our workers compensation line of business as a result of increased severity trends. In 2011, the favorable development on prior accident year direct loss reserves was primarily the result of improvements in severity trends in our personal auto, workers compensation, commercial multi-peril and homeowners lines of business combined with the closing of several large claims.
The Property and Casualty Group maintains several property catastrophe reinsurance treaties with nonaffiliated reinsurers to mitigate future potential catastrophe loss exposures. During 2013, a first treaty provided coverage of up to 90% of a loss of $550 million in excess of the Property and Casualty Group’s loss retention of $350 million per occurrence, a second treaty provided coverage of up to 70% of a loss of $225 million in excess of $900 million, and a third treaty provided coverage of up to 70% of a loss of $25 million in excess of $1.125 billion. The property catastrophe reinsurance treaties that became effective for January 1, 2014 included a first property catastrophe reinsurance treaty providing coverage of up to 30% of a loss of $100 million in excess of the Property and Casualty Group’s loss retention of $300 million per occurrence, a second treaty providing coverage of up to 90% of a loss of $500 million in excess of $400 million, a third treaty providing coverage of up to 85% of a loss of $200 million in excess of $900 million, and a fourth treaty providing coverage of up to 100% of a loss of $25 million in excess of $1.1 billion. There have been no losses subject to these treaties.
The following tables summarize the direct insurance and reinsurance for our property and casualty and life insurance activities, respectively, for the years ended December 31:
The pension plan's expected long-term rate of return represents the average rate of return to be earned on plan assets over the period the benefits included in the benefit obligation are paid. To determine the expected long-term rate of return assumption, we utilized models based upon rigorous historical analysis and forward-looking views of the financial markets based upon key factors such as historical returns for the asset class' applicable indices, the correlations of the asset classes under various market conditions and consensus views on future real economic growth and inflation. The expected future return for each asset class is then combined by considering correlations between asset classes and the volatilities of each asset class to produce a reasonable range of asset return results within which our expected long-term rate of return assumption falls.
The estimated net actuarial loss and prior service cost for the pension plans that will be amortized from accumulated other comprehensive income into pension cost during 2014 are $6 million and $1 million, respectively.
The following table sets forth amounts of benefits expected to be paid over the next 10 years from our pension and other postretirement plans as of December 31:
All full-time and regular part-time employees are eligible to participate in a traditional qualified 401(k) or a Roth 401(k) savings plan. We match 100% of the participant contributions up to 3% of compensation and 50% of participant contributions over 3% and up to 5% of compensation. Matching contributions paid to the plan were $10 million in 2013, $10 million in 2012, and $9 million in 2011. Employees are permitted to invest the employer-matching contributions in our Class A common stock. Employees, other than executive and senior officers, may sell the shares at any time without restriction; sales by executive and senior officers are subject to restrictions imposed by our insider trading policies and the federal securities laws. The plan acquires shares in the open market necessary to meet the obligations of the plan. Plan participants held 0.2 million shares of our Class A common stock at December 31, 2013 and 2012.
The LTIP provides the recipient the right to earn performance shares or units based on the level of achievement of performance goals as defined by us. Performance measures and a peer group of property and casualty companies to be used for comparison are determined by the ECDC. The performance measures for the 2013, 2012 and 2011 awards were the reported combined ratio, growth in direct written premiums and return on invested assets over a three-year performance period as compared to the results of the peer group over the same period. Because the award is based upon a comparison to results of a peer group over a three-year period, the award accrual is based upon estimates of probable results for the remaining performance period. This estimate is subject to variability if our results or the results of the peer group are substantially different than the results we project.
Earned compensation costs are allocated to related entities and reimbursed to Indemnity in cash once the payout is made. The total compensation cost charged to operations related to these LTIP awards was $8 million in 2013, $5 million in 2012, and $9 million in 2011. The related tax benefits recognized in income were $3 million in 2013, $2 million in 2012, and $3 million in 2011.
At December 31, 2013, there was $9 million of total unrecognized compensation cost for non-vested LTIP awards related to open performance periods. Unrecognized compensation is expected to be recognized over a period of two years.
Restricted share awards may be entitled to receive dividends payable during the performance period, or, if subject to performance goals, to receive dividend equivalents payable upon vesting. Restricted share units may be entitled to receive dividend equivalents, which may provide for the crediting of interest or hypothetical reinvestment experience payable after expiration of the performance period.
We have a stock compensation plan for our outside directors to further align the interests of directors with those of our shareholders that provides for a portion of the directors’ annual compensation in shares of our Class A common stock. Each director vests in the grant 25% every three months over the course of a year. Dividends paid by us are reinvested into each directors’ account as additional share credits which vest immediately. Upon ending board service, directors are paid shares of our Class A common stock equal to the number of share credits in their deferred stock account. Our practice is to repurchase shares of our Class A common stock in the open market to satisfy these awards. We do not issue new shares of common stock to directors. The annual charge related to these awards totaled $1 million, $0.5 million and $1 million in 2013, 2012 and 2011, respectively.
In 2012, we repurchased 1,803 shares of our outstanding Class A nonvoting common stock outside of our publicly announced share repurchase program at a total cost of $129,849. Of this amount, 669 and 1,134 shares were purchased in January 2012 and June 2012, respectively, for $50,724, or $75.82 per share, and $79,125, or $69.78 per share, respectively, to settle payments due to two retired senior vice presidents under our long-term incentive plan. These shares were delivered to the plan participants in January 2012 and June 2012, respectively.
Amounts reclassified out of accumulated other comprehensive income (loss) and the related affected line item in the Consolidated Statements of Operations where net income is presented are as follows for the year ended December 31, 2013:
In August 2012, we were notified that we would be subject to an audit of our compliance with the unclaimed property laws of a number of jurisdictions both within and outside our operating territory. The audit commenced in April 2013 and is ongoing. Additionally, EFL has been named in a lawsuit filed by the State Treasurer of West Virginia. The Complaint alleges that EFL has failed to comply with the West Virginia Uniform Unclaimed Property Act. EFL filed a motion to dismiss and a favorable decision was rendered in December 2013 with the Court dismissing the Complaint with prejudice. The State Treasurer appealed the dismissal of the lawsuit in January 2014.
It is probable that ongoing inquiries, audits, and other regulatory activity will result in the payment of additional death claims and escheatment of funds, as well as possible fines. EFL will incur expenses to identify death claims, confirm that benefits are due and notify the beneficiaries. At this time, we are not able to reasonably estimate the possible loss or range of loss related to this issue due to the early stage of development.
The minimum statutory capital and surplus requirements under Pennsylvania and New York law for the Exchange’s property and casualty insurance subsidiaries amounts to $12 million. The Exchange’s property and casualty insurance subsidiaries’ total statutory capital and surplus significantly exceed these minimum requirements, totaling $340 million at December 31, 2013. The risk-based capital levels of all members of the Property and Casualty Group and EFL significantly exceed the minimum requirements. Cash and securities with a carrying value of $15 million were deposited by the property and casualty and life entities with regulatory authorities under statutory requirements at December 31, 2013.
As prescribed by the Insurance Department of the Commonwealth of Pennsylvania, the Exchange records unearned subscriber fees (fees to the attorney-in-fact) as deductions from unearned premium reserve and charges current operations on a pro-rata basis over the periods covered by the policies. The Pennsylvania-domiciled members of the Property and Casualty Group discount workers compensation loss reserves on a non-tabular basis as prescribed by the Insurance Department of the Commonwealth of Pennsylvania. The Exchange’s NAIC prepared statutory surplus, excluding the impact of the Pennsylvania prescribed practices, would have been $5.9 billion at December 31, 2013. EIC’s NAIC prepared statutory surplus, excluding the impact of the Pennsylvania prescribed practices, would have been $290 million at December 31, 2013. EPC and Flagship record the discounting of workers compensation loss reserves on a direct basis, however, after application of the intercompany pooling arrangement, there is no impact on their financial statements.
Note receivable from EFL - Indemnity is due $25 million from EFL in the form of a surplus note that was issued in 2003. The note may be repaid only out of unassigned surplus of EFL. Both principal and interest payments are subject to prior approval by the Pennsylvania Insurance Commissioner. The note bears an annual interest rate of 6.7% and will be payable on demand on or after December 31, 2018, with interest scheduled to be paid semi-annually, subject to prior approval by the Pennsylvania Insurance Commissioner. Indemnity recognized interest income on the note of $2 million in 2013 and 2012.
Cash settlements for payments on the account of the Exchange totaled $351 million, $343 million and $325 million in 2013, 2012 and 2011, respectively, and $32 million, $30 million and $28 million in 2013, 2012 and 2011, respectively, for EFL. These reimbursements are settled on a monthly basis.