field office operates out of the home office complex. We incurred net rent expense for both the home office complex and the field offices leased from the Exchange totaling $5.6 million in 2008.
The total operating expense, including rent expense, for all office space we occupied in 2008 was $22.6 million. This amount was reduced by reimbursements from affiliates of $14.4 million. This net amount after allocations is reflected in our cost of management operations.
Includes 1.9 million shares of our Class A nonvoting common stock from the F. William Hirt Estate separate from our stock repurchase program.
At December 31, 2006, shareholders’ equity decreased by $21.1 million, net of taxes, as a result of initially applying the recognition provisions of Statement of Financial Accounting Standards No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.”
The following discussion of financial condition and results of operations highlights significant factors influencing our Company. 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 operating results.
The discussions below focus heavily on our three segments: management operations, insurance underwriting operations and investment operations. The segment basis financial results presented throughout Management’s Discussion and Analysis herein are those which management uses internally to monitor and evaluate results and are a supplemental presentation of our Consolidated Statements of Operations.
Because we are a management company, our earnings are driven largely by the management fee revenue we collect from the Exchange that is based on the direct written premiums of the Property and Casualty Group. The property/casualty insurance industry is highly cyclical, with periods of rising premium rates and shortages of underwriting capacity (“hard market”) followed by periods of substantial price competition and excess capacity (“soft market”). The property/casualty insurance industry has been well capitalized in recent years, however, the turmoil in the securities markets, the volatile economic environment, and the return of severe tropical storm losses have all taken a toll on 2008 industry results. Conning Research & Consulting estimates the industry combined ratio to be 106.3 in 2008, which is a deterioration from the actual industry combined ratio of 95.6 in 2007. While favorable loss reserve development benefited industry underwriting results, continued price softening, high catastrophe losses and significant underwriting losses contributed to the 2008 deterioration. These market conditions for insurers may be a precursor to increases in pricing on property and casualty policies. Conning Research & Consulting is predicting that slower economic growth in 2009 will contribute to slow exposure growth. While premium rates appear to be hardening, the effect of the softening economy, in terms of auto and home sales, could lead to weakness in the growth of top line premium.
Our alternative investments were also impacted by the 2008 market declines. Equity in earnings of limited partnerships decreased $54.0 million in 2008 over 2007. The valuation adjustments in the limited partnerships are based on information received from our general partners, which is generally received on a quarter lag. As a result, the 2008 partnership earnings do not reflect the valuation changes that were impacted by the upheaval in the financial markets in the fourth quarter of 2008.
Second, we generate revenues from our property/casualty insurance subsidiaries, which consist of our share of the pooled underwriting results of the Property and Casualty Group. All members of the Property and Casualty Group pool their underwriting results. Under the pooling agreement, the Exchange assumes 94.5% of the Property and Casualty Group’s net written premium. Through the pool, our subsidiaries, Erie Insurance Company and Erie Insurance Company of New York, currently assume 5.5% of the Property and Casualty Group’s net written premium, providing a direct incentive for us to manage the insurance underwriting discipline as effectively as possible.
Decrease in net income per share-diluted in 2008 was driven by net realized losses on investments as a result of the upheaval in the financial markets, particularly in the third and fourth quarters of 2008. In the year, we recognized $69.5 million of impairment charges on fixed maturities and preferred stock, $38.6 million of net realized losses on common stock and a drop in our equity in earnings of limited partnerships of $54.0 million.
favorable development on prior accident year loss reserves of 3.2 points, or $6.7 million, in 2008, compared to 5.3 points, or $11.0 million, of favorable development in 2007; and
increase in the underlying non-catastrophe accident year combined ratio as a result of slightly declining average premiums and increased loss costs.
Net investment income decreased 16.4% in 2008 compared to 2007, as invested assets declined in 2008 to fund stock repurchases of $102.0 million.
Equity in earnings of limited partnerships decreased to $5.7 million in 2008 from $59.7 million in 2007 as a result of fair value declines across all limited partnerships categories due to lingering anemic financial market conditions.
In order to prepare financial statements in accordance with GAAP, we make estimates and assumptions that have a significant effect on reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period and related disclosures. Management considers an accounting estimate to be critical if (1) it requires assumptions to be made that were uncertain at the time the estimate was made, and (2) different estimates that could have been used, or changes in the estimate that are likely to occur from period-to-period, could have a material impact on our consolidated statements of operations or financial position.
significantly from the underlying assumptions, there could be material adjustments to prior estimates that could potentially adversely affect our results of operations, financial condition and cash flows. The estimates and the estimating methods used are reviewed continually, and any adjustments considered necessary are reflected in current earnings.
short- and long-term prospects of the issuer and its industry based on analysts’ recommendations;
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 volatility in market conditions experienced in the fourth quarter 2008. We expect additional deterioration to be reflected in the general partners’ year end financial statements, which we will receive in 2009, and such declines could be significant. Nearly all of the underlying investments in our limited partnerships are valued using a source other than quoted prices in active markets. Our limited partnership holdings are considered investment companies where the general partners record assets at fair value. Several factors are to be considered in determining whether an entity is an investment company. Among these factors are a large number of investors, low level of individual ownership and passive ownership that indicate the entity is an investment company.
Our actuaries review reserve estimates for both current and prior accident years using the most current claim data, on a quarterly basis, for all direct reserves except the reserves for the pre-1986 automobile catastrophic injury claims and the workers compensation catastrophic injury claims that are reviewed semi-annually. These catastrophic injury reserves are reviewed semi-annually because of the relatively low number of cases and the long-term nature of these claims. For reserves that are reviewed semi-annually, our actuaries monitor the emergence of paid and reported losses in the intervening quarters to either confirm that the estimate of ultimate losses should not change, or if necessary, perform a reserve review to determine whether the reserve estimate should change. Significant changes to the factors discussed above, which are either known or reasonably projected through analysis of internal and external data, are quantified in the reserve estimates each quarter.
The Property and Casualty Group reduced reserves related to automobile bodily injury (BI) and uninsured/underinsured motorist (UM/UIM) bodily injury by approximately $75 million in 2008. This change in estimate resulted from improvements in frequency trends, and to a lesser extent, severity trends, that developed primarily on 2006 and 2007 accident years. The Property and Casualty Group’s reserves for auto BI and UM/UIM were $766 million at December 31, 2007 and $700 million at December 31, 2008.
The pre-1986 automobile catastrophic injury reserves were reduced by approximately $30 million in 2008. This change in estimate resulted from lower than expected future attendant care costs and affected various accident years before 1986. These reserve estimates were reduced to reflect reduced attendant care costs on these claims. The additional data was incorporated in the reserve estimates as it became known in each quarter throughout 2008. The Property and Casualty Group had pre-1986 automobile catastrophic injury reserves of $299.0 million at December 31, 2007 and $265.1 million at December 31, 2008, which are net of $163.2 million and $153.9 million of anticipated reinsurance recoverables for 2007 and 2008, respectively.
In 2007 and 2006, the Property and Casualty Group’s direct reserves had an estimated redundancy at December 31 of $200.6 million, or 5.6% of reserves, and $73.1 million, or 1.9% of reserves, respectively. The favorable frequency and severity trends in automobile BI and UM/UIM began in 2006 and these trends developed more fully in 2007. In 2008, the trends reflected in the 2007 activity were incorporated into our reserve estimates.
At December 31, 2008, the reserve carried by the Property and Casualty Group for the pre-1986 automobile catastrophic injury liabilities, which is our best estimate of this liability at this time, was $265.1 million, which is net of $153.9 million of anticipated reinsurance recoverables. Our property/casualty subsidiaries’ share of the net
Our pension plan for employees is the largest and only funded benefit plan we offer. Our pension and other retirement benefit obligations are developed from actuarial estimates in accordance with Financial Accounting Standard (SFAS) 87, “Employers’ Accounting for Pensions.” Several statistical and other factors, which attempt to anticipate future events, are used in calculating the expense and liability related to the plans. Key factors include assumptions about the discount rates and expected rates of return on plan assets. We review these assumptions annually and modify them considering historical experience, current market conditions, including changes in investment returns and interest rates, and expected future trends.
Accumulated and projected benefit obligations are expressed as the present value of future cash payments. We discount those cash payments using the prevailing market rate of a portfolio of high-quality fixed-income debt instruments with maturities that correspond to the payment of benefits. Lower discount rates increase present values and subsequent year pension expense; higher discount rates decrease present values and subsequent year pension expense. In determining the discount rate, we performed a bond-matching study. The study developed a portfolio of non-callable bonds rated AA- or higher with at least $25 million outstanding at December 31, 2008. These bonds had maturities primarily between zero and thirty years. For years beyond year 30, there were no bonds maturing. In these instances, the study estimated the appropriate bond by assuming that there would be bonds available with the same characteristics as the available bond maturing in the immediately preceding year. Outlier bonds were excluded from the study. The cash flows from the bonds were matched against our projected benefit payments in the pension plan, which have a duration of about 18 years. This bond-matching study supported the selection of a 6.06% discount rate for the 2009 pension expense. The 2008 expense was based on a discount rate assumption of 6.62%. A change of 25 basis points in the discount rate assumption, with other assumptions held constant, would have an estimated $1.7 million impact on net pension and other retirement benefit costs in 2009, before consideration of expense allocation to affiliates.
Unrecognized actuarial gains and losses are being recognized over a 15-year period, which represents the expected remaining service period of the employee group. Unrecognized actuarial gains and losses arise from several factors, including experience and assumption changes in the obligations and from the difference between expected returns and actual returns on plan assets. These unrecognized losses are recorded in the pension plan obligation on the Statements of Financial Position and Accumulated Other Comprehensive Income in 2008 in accordance with FAS 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.” These amounts are systematically recognized as an increase to future net periodic pension expense in accordance with FAS 87 in future periods.
The expected long-term rate of return for the pension plan represents the average rate of return to be earned on plan assets over the period the benefits included in the benefit obligation are to be paid. The expected long-term rate of return is less susceptible to annual revisions, as there are typically not significant changes in the asset mix. The long-term rate of return is based on historical long-term returns for asset classes included in the pension plan’s target allocation. A reasonably possible change of 25 basis points in the expected long-term rate of return assumption, with other assumptions held constant, would have an estimated $0.8 million impact on net pension benefit cost before consideration of reimbursement from affiliates.
The actuarial assumptions used by us in determining our pension and retirement benefits 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 or results of operations. Further information on our retirement benefit plans is provided in Item 8. “Financial Statements and Supplementary Data - Note 10 of Notes to Consolidated Financial Statements” contained within this report.
See Item 8. “Financial Statements and Supplementary Data - Note 2 of Notes to Consolidated Financial Statements” contained within this report for a discussion of recently issued accounting pronouncements.
Year-over-year average premium per policy decreased 2.5% to $949 in 2008 from $973 in 2007.
Costs other than commissions increased 5.5% while commission costs decreased 0.6% in 2008.
$4.7 million as a result of higher average pay rates and staffing levels;
executive severance costs totaled $2.9 million in 2008 compared to $3.3 million in 2007; and
All other operating costs increased 3.1%, or $1.8 million driven by a $5.2 million increase in consulting fees and $2.8 million increase in hardware and software costs primarily related to various information technology initiatives. In 2007, we recorded a $4.3 million charge for a judgment against us.
The following table presents the direct written premium of the Property and Casualty Group, shown by major line of business, and the calculation of our management fee revenue.
Management fees are returned to the Exchange when policyholders cancel their insurance coverage mid-term and unearned premiums are refunded to them. We maintain an allowance for management fees returned on mid-term policy cancellations that recognizes the management fee anticipated to be returned to the Exchange based on historical mid-term cancellation experience. In 2008, although the mid-term cancellations of policies for the Property and Casualty Group trended downward, the slight increase in the unearned premium reserve in 2008 resulted in an increase in the allowance for management fees returned on cancelled policies. The policy retention ratio improved to 90.6% at December 31, 2008, compared to 90.2% at December 31, 2007, and 89.5% at December 31, 2006. Our cash flows are unaffected by the recording of this allowance.
Direct written premiums of the Property and Casualty Group increased 0.4% in 2008 due to an increase in policies in force of 2.9%, offset by rate reductions taken in 2008 and 2007. Total policies in force increased to 4,002,209 in 2008, from 3,888,333 in 2007 and 3,798,297 in 2006. Growth in policies in force is the result of continuing improvements in policyholder retention and increased new policies sold. The year-over-year average premium per policy for all lines of business decreased 2.5% to $949 in 2008, from $973 in 2007. The impact of rate reductions is seen primarily in renewal premiums.
Premiums generated from renewal business remained relatively flat at $3.4 billion in 2008, 2007 and 2006, increasing 0.1% in 2008 compared to a decrease of 1.5% in 2007. Renewal policies in force increased 2.9% to 3,522,261 in 2008 from 3,422,936 in 2007. The year-over-year average premium per policy on renewal business decreased 2.7% to $962 in 2008 from $989 in 2007, which was 3.3% less than the $1,022 in 2006. The Property and Casualty Group’s policy retention ratio has been steadily improving to a twelve-month moving average of 90.6% in 2008, up from 90.2% in 2007 and 89.5% in 2006.
The Property and Casualty Group implemented rate reductions in 2006, 2007 and 2008 to be more price-competitive for potential new policyholders and to improve retention of existing policyholders. The Property and Casualty Group writes only one-year policies. Consequently, rate actions take 12 months to be fully recognized in written premium and 24 months to be recognized fully in earned premiums. Since rate changes are realized at renewal, it takes 12 months to implement a rate change to all policyholders and another 12 months to earn the decreased or increased premiums in full. As a result, certain rate actions approved in 2007 were reflected in written premium in 2008, and some rate actions in 2008 will be reflected in 2009. The effect on 2008 premiums written of all rate actions resulted in a net decrease in written premiums of $30.3 million. The Property and Casualty Group’s most significant rate reductions in 2008 were in workers compensation in Pennsylvania and homeowners in Maryland and Pennsylvania. As the industry appears to be moving toward market-firming, the 2009 rate actions sought by the Property and Casualty Group are expected to increase premiums in 2009. We continuously evaluate pricing actions and estimate that those approved, filed and contemplated for filing during 2009 could result in a net increase to direct written premiums of approximately $36 million in 2009, in the private passenger auto line of business in Pennsylvania and Maryland.
The Property and Casualty Group’s 0.5% decrease in direct written premiums in 2007, compared to 2006, resulted from more significant rate reductions in lines of business under competitive pressure, such as private passenger auto. The effect on 2007 premiums written from rate actions resulted in a net decrease in written premiums of $85.9 million, while the effect on 2006 premiums written from rate actions resulted in a net decrease of $119.5 million in written premiums.
Industry private passenger auto premiums for 2009 are expected to experience minimal growth as rates may begin to firm, but be offset by slower exposure growth given the current economic conditions. Industry homeowners premiums in 2009 are expected to experience rate firming but also be affected by low exposure growth as the difficult housing market conditions continue.
Commercial lines - Driving the premium decreases in our major commercial lines in 2008 compared to 2007 are lower renewal premiums, which decreased 3.4% to $961.4 million in 2008 from $995.5 million in 2007, reflecting the impact of rate reductions being implemented over the past three years. Despite the decreases in renewal premiums, commercial lines new business premiums written increased 3.9% to $145.5 million in 2008, from $140.1 million in 2007, which had increased 16.3% from $120.4 million in 2006. The year-over-year average premium per policy on commercial lines new business increased 1.3% to $1,641 in 2008, from $1,621 in 2007
Renewal premiums written for commercial lines decreased 3.4% during 2008 and 4.3% during 2007. The overall decrease is reflective of the impact of rate reductions and changes in the mix of business. In 2007 we discontinued dividends on certain workers compensation policies and instead implemented a tiered pricing structure to better align rates and associated risks. The year-over-year policy retention ratio for commercial lines was 85.3%, 85.7% and 85.4% in 2008, 2007 and 2006, respectively.
Future trends-premium revenue - We are continuing our efforts to grow Property and Casualty Group premiums and improve our competitive position in the marketplace. Expanding the size of the agency force will contribute to future growth as new agents build up their book of business with the Property and Casualty Group. In 2008, we appointed 156 new agencies and had a total of 2,042 agencies as of December 31, 2008. We will continue to appoint agencies in 2009 with a goal of appointing 127 new agencies. In the third quarter of 2008, we decided not to pursue our planned 2009 expansion effort into the state of Minnesota in order to refocus our business strategy to our current markets where we expect to realize a higher return more quickly than by expanding into another state. Our pricing actions described above could result in an increase in direct written premium of about $36 million in 2009. The current economic conditions could also impact the average premium written by the Property and Casualty Group as consumers reduce coverages and there are fewer automobiles and homes sold.
Service agreement revenue includes service charges we collect from policyholders for providing extended payment terms on policies written by the Property and Casualty Group. The service charges are fixed dollar amounts per billed installment. Service agreement revenue amounted to $32.3 million in 2008, $29.7 million in 2007 and $29.2 million in 2006. Service agreement revenue increased in 2008 by $2.9 million due to late payment and policy reinstatement fees that became effective March 1, 2008. The 2007 service agreement revenue decreased from 2006 due to a shift to the no-fee, single payment plan driven by a discount in pricing offered for paid-in-full policies as well as consumers’ desire to not incur service charges.
an increase in normal and accelerated rate commissions of $6.8 million driven by an increase in certain commercial commission rates and higher accelerated commissions due to agency appointments in recent years, and
an increase in promotional incentives and the private passenger auto bonus of $5.1 million.
Executive severance costs totaled $2.9 million in 2008 compared to $3.3 million in 2007.
Sales and policy issuance costs increased $6.1 million due to increased spending on agent advertising programs.
Agent bonuses and promotional incentives - Agent bonuses are based on an individual agency’s property/casualty underwriting profitability over a three-year period. There is also a growth component to the bonus, paid only if the agency is profitable. The estimate for the bonus is modeled on a monthly basis using the two prior years’ actual
underwriting data by agency combined with the current year-to-date actual data. Agent bonuses decreased $14.6 million in 2008 as our estimate of the profitability component of the bonus decreased when factoring in the most recent year’s underwriting data. The agent bonus award was estimated at $80.1 million for 2008. Of this estimate, $77.0 million represents the profitability component and $3.1 million represents the growth component of the award. The 1.2% increase in 2007 compared to 2006 was due to the three-year period covered by the bonus including the years with our strongest underwriting profitability. Other promotional incentives increased in 2008 primarily due to a program that ran from October 2007 through September 2008 that contributed $2.0 million to 2008 expense compared to $0.7 million in 2007.
Sales and policy issuance costs increased $6.1 million in 2008 due to increased spending on agent advertising programs. All other operating costs increased 3.1% in 2008. Consulting fees increased $5.2 million compared to 2007, which included $5.4 million of contract labor costs related to various technology initiatives. Hardware and software costs increased $2.8 million primarily related to these technology initiatives. In 2007, all other operating costs included a $4.3 million accrual for a judgment against us in a lawsuit arising from our termination of an agency.
Future trends-cost of management operations - The competitive position of the Property and Casualty Group is based on many factors including price considerations, service levels, ease of doing business, product features and billing arrangements, among others. Pricing of Property and Casualty Group policies is directly affected by the cost structure of the Property and Casualty Group and the underlying costs of sales, underwriting activities and policy issuance activities performed by us for the Property and Casualty Group. Since 2006, management has worked to better align our growth in costs to our growth in premium over the long-term. Our goal for 2008 was to hold growth in non-commission costs to 9% or less. Actual growth in non-commission costs for 2008 was 5.5%.
Our estimate for growth in non-commission operating expenses for the year 2009 is 16%. For 2009, our retirement plan GAAP benefit expenses are expected to increase approximately $10 million for all retirement plans as the assumed discount rate used to calculate the pension costs decreased from the 6.62% used in 2008 to 6.06% for 2009. Although we are the sponsor of these postretirement plans and record on our balance sheet the funded status of these plans, generally the Exchange and EFL reimburse the Company for about 50% of the annual benefit expense of these plans. Also in 2009, we will continue various information technology initiatives aimed at improving our operating performance, and as a result, expect to incur additional external expenses of approximately $30 million. See also “Factors That May Affect Future Results.”
Development of prior accident year loss reserves, excluding salvage and subrogation recoveries, improved the GAAP combined ratio by 3.2 points in 2008, compared to 5.3 points in 2007.
The GAAP loss and LAE ratio, expressed as a percentage, is the ratio of losses and loss adjustment expenses incurred to earned premiums for our property/casualty insurance subsidiaries.
The GAAP combined ratio, expressed as a percentage, is the ratio of losses, loss adjustment, acquisition and other underwriting expenses incurred to earned premiums for our property/casualty insurance subsidiaries. Our GAAP combined ratios are different than the results of the Property and Casualty Group due to certain GAAP adjustments.
The commercial lines adjusted statutory combined ratio increase in 2008 over 2007 is primarily due to one large fire claim in Pennsylvania and losses related to Hurricane Ike in Ohio, Pennsylvania and Indiana and less favorable prior year development in 2008 compared to 2007.
Our 5.5% share of the Property and Casualty Group’s favorable development of prior accident year losses, after removing the effects of salvage and subrogation recoveries, was $6.7 million in 2008 and improved the combined ratio by 3.2 points. Of the $6.7 million, $4.3 million related to the personal auto line of business. The Property and Casualty Group reduced reserves in 2008 on prior accident years as a result of improvements in frequency trends and slight improvements in severity trends on automobile bodily injury and on uninsured/underinsured motorist bodily injury. For private passenger auto comprehensive coverages in 2008, the severity trend outpaced improvements in frequency, causing an increase in the loss cost trend. For all other private passenger auto coverages, the Property and Casualty Group’s frequency improvements either offset or outpaced increases in severity, causing flattening or improving loss cost trends. Overall, loss costs for private passenger auto continue to remain relatively flat.
In 2007, our share of the Property and Casualty Group’s favorable development of prior accident year losses, after removing the effects of salvage and subrogation recoveries, was $11.0 million and improved the combined ratio by 5.3 points. Of the $11.0 million, $8.1 million related to the personal auto line of business. The Property and Casualty Group reduced reserves in 2007 on prior accident years as a result of sustained improved severity trends on automobile bodily injury and on uninsured/underinsured motorist bodily injury. In 2006, the positive development of 1.9 points, or $4.0 million, was the result of improved frequency trends for automobile bodily injury and uninsured/underinsured motorist bodily injury, from the 2004 and 2005 accident years. The total favorable development of 3.9 points was offset by 2.0 points, or $4.2 million, for reserve strengthening of the pre-1986 automobile catastrophic injury liability reserve.
During 2008, 2007 and 2006, our share of catastrophe losses, as defined by the Property and Casualty Group, amounted to $7.0 million, $3.6 million and $8.5 million, respectively, or 3.4 points, 1.7 points and 4.0 points, respectively, of the loss ratio. The Property and Casualty Group’s actuarially projected mean catastrophe level is 6.6 loss ratio points per accident year. Catastrophe losses in 2008 were impacted by flooding, tornado and wind storms related to Hurricane Ike primarily in Ohio and Pennsylvania. In 2007, the catastrophe losses resulted from wind and rainstorms in Ohio and Pennsylvania. Storm-related losses were closer to expected levels in 2006, with wind and hailstorms concentrated primarily in Indiana and Ohio driving a majority of these catastrophe losses.
Net realized losses on investments in 2008 primarily include impairment charges of $69.5 million on fixed maturities and preferred stock and net realized losses on common stock of $38.6 million. Beginning January 1, 2008, we reclassified our common stock portfolio to trading from available-for-sale. With this change, unrealized gains and losses are now reported in earnings as realized gains and losses.
Equity in earnings of limited partnerships decreased $54.0 million in 2008 primarily as a result of fair value depreciation.
Equity in losses of EFL was $14.6 million in 2008 primarily driven by EFL’s recognition of impairment charges on investments as a result of the turmoil in the financial markets. A deferred tax asset valuation allowance was recorded for impairments where the related deferred tax asset is not expected to be realized.
Some of the securities represented in the table above were previously impaired and written down to a new cost basis. The table reflects additional losses on those securities held at December 31, 2008. We completed a thorough review of the securities based upon our impairment and valuation review process. Our analysis included a review of current market risk factors as well as issuer specific factors including credit impairments and ability to pay current obligations. We determined that these securities are stressed due to the current unprecedented financial market conditions and we continue to have the intent and ability to hold these investments for the periods of time that we anticipate are needed to recover while continuing to collect their interest and dividend cash flows.
Year-to-date, valuation losses on common stock that were reported in earnings was $21.7 million. See Item 8. “Financial Statements and Supplementary Data - Note 5 of Notes to Consolidated Financial Statements” contained within this report for additional information on our adoption of SFAS 159.
We have audited Erie Indemnity Company’s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Erie Indemnity Company’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
In our opinion, Erie Indemnity Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on the COSO criteria.
We are the attorney-in-fact for the subscribers of Erie Insurance Exchange (Exchange), a reciprocal insurance exchange. We perform certain services for the Exchange relating to the sales, underwriting and issuance of policies on behalf of the Exchange and earn a management fee for these services. The Exchange is a Pennsylvania-domiciled property/casualty insurer rated A+ (Superior) by AM Best. The Exchange is the 22nd largest property/casualty insurer in the United States based on 2007 net premiums written for all lines of business. The Exchange and its wholly-owned subsidiary, Flagship City Insurance Company (Flagship) and our wholly-owned subsidiaries, Erie Insurance Company (EIC), Erie Insurance Company of New York (EINY) and the Erie Insurance Property and Casualty Company (EIPC), comprise the Property and Casualty Group. The Property and Casualty Group is a regional insurance group operating in 11 Midwestern, Mid-Atlantic, and Southeastern states and the District of Columbia. The Property and Casualty Group primarily writes personal auto insurance, which comprises 48% of its direct premiums. Members of the Property and Casualty Group are subject to statutory regulations and are required to file reports in accordance with statutory accounting principles with the regulatory authorities. We also own 21.6% of the common stock of the Erie Family Life Insurance Company (EFL), an affiliated life insurance company; the Exchange owns the remaining 78.4%. We, together with the Property and Casualty Group and EFL, operate collectively as the Erie Insurance Group (Group).
The preparation of financial statements in conformity with U.S. generally accepted accounting principles 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.
Available-for-sale securities - Fixed maturity and preferred stock securities are classified as available-for-sale and are reported at fair value. Unrealized holding gains and losses, net of related tax effects, on fixed maturities and preferred stock are charged or credited directly to shareholders’ equity as accumulated other comprehensive (loss) income.
Fixed income and preferred stock securities are evaluated monthly for other-than-temporary impairment loss. Some factors considered in evaluating whether a decline in fair value is other-than-temporary include:
specific events that occurred affecting the issuer, including a ratings downgrade; and
Perpetual preferred securities and hybrid preferred securities are evaluated without considering any debt-like characteristics. We believe this approach to be more conservative since the lack of a final maturity and unlikelihood of a call means recovery is uncertain and would occur over a multi-year period. We also consider whether we have the intent and ability to hold these types of securities until recovery.
Trading securities - Common stock securities were reclassified from available-for-sale at December 31, 2007 to trading in the first quarter of 2008 with our adoption of SFAS 159. Common stock securities are reported at fair value. As of January 1, 2008, unrealized gains and losses on these securities are included in net realized (losses) gains in the Consolidated Statements of Operations. Realized gains and losses on sales of common stock are recognized in income based upon the specific identification method. Dividend income is recognized as earned.
Limited partnerships - Limited partnerships include U.S. and foreign private equity, real estate and mezzanine debt investments. The private equity limited partnerships invest primarily in small- to medium-sized companies. Limited partnerships are recorded using the equity method. The general partners for our limited partnerships determine the market value of investments in the partnerships including any other-than-temporary impairments of these individual investments. We evaluate monthly other-than-temporary impairments of limited partnerships at the fund level when the market value of fund assets is less than our cost basis.
Included in service agreement revenue are service charges we collect from policyholders for providing multiple payment plans on policies written by the Property and Casualty Group. Service charges, which are flat dollar charges for each installment billed beyond the first installment, are recognized as revenue when bills are rendered to the policyholder.
Agent bonuses are based on an individual agency’s property/casualty underwriting profitability and also include a component for growth in agency property/casualty premiums if the agency’s underwriting profitability targets for our book of business are met. The estimate for agent bonuses, which are based on the performance over 36 months, is modeled on a monthly basis using actual underwriting data by agency for the two prior years combined with the current year-to-date actual data and projected underwriting data for the remainder of the current year. At December 31 of each year, we use actual data available and record an accrual based on the expected payment amount. These costs are included in the cost of management operations in the Consolidated Statements of Operations.
SFAS 157 provides guidance for using fair value to measure assets and liabilities and enhances disclosures about fair value measurement (see Note 2). The standard describes three levels of inputs that may be used to measure fair value, which are provided below.
Quoted prices for identical instruments in active markets. Such prices are obtained from third party nationally recognized pricing services. Level 1 securities primarily include publicly traded common stock, nonredeemable preferred stocks and treasury securities.
Observable inputs other than quoted prices in Level 1. These would include prices obtained from third party pricing services that model prices based on observable inputs. Included in this category are primarily municipal securities, asset backed securities, collateralized-mortgage obligations, foreign and domestic corporate bonds and redeemable preferred stocks. Nonredeemable preferred stocks for which a quote in an active market is unavailable and a value is obtained from a third party pricing service are also included in this level.
The following tables provide a reconciliation of assets measured at fair value on a recurring basis for securities using Level 3 inputs for the three months ended December 31, 2008:
Effective January 1, 2008, the Company adopted SFAS 159 for our common stock portfolio. See Note 2. The following table represents the December 31, 2007 carrying value of these assets, the transition adjustment booked to retained earnings and the carrying value as of January 1, 2008.
The following tables summarize the cost and fair value of available-for-sale securities at December 31, 2008 and 2007:
The amortized cost and estimated fair value of fixed maturities at December 31, 2008, are shown below by remaining contractual term to maturity. Mortgage-backed securities are allocated based on 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.
In December of 2008 we sold our interest in ten limited partnership investments generating a net realized gain. There were two sales of limited partnership interests in 2007 and no sales in 2006.
Our limited partnerships are classified into three primary categories based upon the unique investment characteristic of each: private equity, mezzanine debt and real estate. Nearly all of the underlying investments in our limited partnerships are valued using a source other than quoted prices in active markets. The fair value amounts for our private equity and mezzanine debt partnerships are based on the financial statements of the general partners, who use various methods to estimate fair value including the market approach, income approach and/or the cost approach. The market approach uses prices and other pertinent information from market-generated transactions involving identical or comparable assets or liabilities. Such valuation techniques often use market multiples derived from a set of comparables. The income approach uses valuation techniques to convert future cash flows or earnings to a single discounted present value amount. The measurement is based on the value indicated by current market expectations about those future amounts. The cost approach is derived from the amount that is currently required to replace the service capacity of an asset. If information becomes available that would impair the cost of these partnerships, then the general partner would generally adjust to the net realizable value.
The number of limited partnerships was reduced to 77 at December 31, 2008 from 95 at December 31, 2007 as a result of sales and dissolutions.
We had loaned securities included as part of our invested assets with a fair value of $17.5 million and $29.4 million at December 31, 2008 and 2007, respectively. We have incurred no losses on the securities lending program since the program’s inception.
We adopted FAS 159, “The Fair Value Option for Financial Assets and Liabilities” on January 1, 2008 for our common stock portfolio. Changes in fair value of these securities, which were previously recorded in other comprehensive income, are now recognized in earnings as they occur. The cumulative effect adjustment for our common stock portfolio increased retained earnings and reduced other comprehensive income by $11.2 million, net of tax. See also Note 5.
EFL is a Pennsylvania-domiciled life insurance company operating in 10 states and the District of Columbia. We own 21.6% of EFL’s common shares outstanding accounted for using the equity method of accounting. Our share of EFL’s undistributed earnings included in retained earnings as of December 31, 2008 and 2007, totaled $44.4 million and $59.1 million, respectively.
The liabilities for the plans described in this note are presented in total for all employees of the Group. The gross liability for the pension and retiree health benefit plans is presented in the Consolidated Statements of Financial Position as employee benefit obligations. A portion of annual expenses related to the pension and retiree health benefit plans are allocated to related entities within the Group as incurred. We are reimbursed approximately 50% of the net periodic benefit cost for the pension plans and postretirement health plans by the Exchange and EFL.
The 2007 actuarial gain was primarily due to an increase in the discount rate assumption used to estimate the future benefit obligation from 6.25% in 2006 to 6.62% in 2007. The 2006 actuarial gain was primarily due to an increase in the discount rate assumption used to estimate the future benefit obligation from 5.75% in 2005 to 6.25% in 2006, and actual return on plan assets significantly exceeding estimates.
In December 2007, employment agreements for certain members of executive management were signed which incorporated a payment in full of accrued SERP benefits at December 2008 in a lump sum payment, after which time no additional SERP benefits would accrue for them. This resulted in a $3.7 million curtailment in 2007 in the benefit obligations calculation and a $0.5 million curtailment in the 2007 net periodic benefit cost. The payment of certain of these benefits resulted in the $10.7 million settlement in the 2008 benefit obligation and $0.2 million settlement gain in the 2008 periodic benefit cost. The 2008 termination charge of $0.4 million relates to two of these members of executive management whose SERP payouts will occur in 2009.
The 2007 impact was due to settlements related to the annuity purchases and lump sum payouts made to three participants who retired in 2006.
Amounts recognized in other comprehensive income for the years ended December 31 for pension plans were as follows:
2007 amendment charges related to five new participants in the SERP January 1, 2007.
The estimated net actuarial loss and prior service cost for the pension plans that will be amortized from accumulated other comprehensive income into net periodic benefit cost during 2009 are $3.6 million and $0.3 million, respectively.
* Certain members of executive management were paid their full SERP benefits in a lump sum payment in December 2008, after which time no additional SERP benefits will accrue for them.
The estimated amortization of prior service credit for the retiree health benefit plan that will be amortized from accumulated other comprehensive income into net periodic benefit cost during 2009 is $0.1 million.
* The expected benefit payments as of December 31, 2006, reflect the change in coverage to include five years of benefits regardless of a participant’s age on the date of retirement. The 2005 benefit payments were based on fewer years of coverage per participant, as the benefit was calculated from the age of retirement to 65, which could have been less than five years.
We have a qualified 401(k) savings plan for our employees. Eligible participants are permitted to make contributions to the plan up to the Internal Revenue Service limit. 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. All full-time and regular part-time employees are eligible to participate in the plan. Matching contributions paid to the plan were $8.2 million, $8.0 million and $7.9 million in 2008, 2007 and 2006, respectively, before reimbursements from affiliates. Matching contributions after reimbursements from affiliates were $3.5 million in 2008 and $3.4 million in each of the years 2007 and 2006. Employees are permitted to invest the employer-matching contributions in our Class A common stock and may sell the shares at any time without restriction. The plan acquires shares in the open market necessary to meet the obligations of the plan. Plan participants held 0.1 million of our Class A shares at December 31, 2008, 2007 and 2006. Effective January 1, 2007, all full-time and regular part-time employees are eligible to participate in a Roth 401(k) in lieu of the traditional 401(k). The employer-matching provisions are the same as our current 401(k) plan described above. Liabilities for the 401(k) plan are presented in the Consolidated Statements of Financial Position as accounts payable and accrued expenses.
We have separate annual and long-term incentive plans for our executive and senior management and regional vice presidents. We also make available deferred compensation plans for executive and senior management and certain outside directors.
The cost of the plan is charged to operations as the compensation is earned over the performance period of one year. Earned amounts are allocated to related entities as incurred and settled in cash once the payout is made. The amount charged to expense for the annual incentive plan bonus before allocation to affiliates was $3.8 million, $2.2 million and $2.7 million for 2008, 2007 and 2006, respectively. After allocation to affiliates, our expense was $2.6 million, $1.7 million and $1.8 million for 2008, 2007 and 2006, respectively.
At December 31, 2008, all shares awarded for the 2003-2005 performance period vested. The average grant price for the 2003-2005 performance period was $52.65. The plan award of $0.5 million was paid in January 2009. Our share of this payment was $0.3 million.
At December 31, 2008, the awards for the 2006-2008 performance period were fully vested in accordance with the 2004 LTIP plan. The awards for this performance period will be calculated upon receipt of final financial information for the peer group. The estimated award based on the peer group information as of September 30, 2008, is 58,880 shares. The grant price will be the average of the high and low stock price on the date the award is paid. Our stock price as of January 30, 2009, was $35.45.
The deferred compensation plans are arrangements for our executive, senior and regional vice presidents whereby the participants can elect to defer receipt of a portion of their compensation until a later date. Those participating in the plans select hypothetical investment funds for their deferrals and are credited with the hypothetical returns generated. Supplemental employee contributions to the deferred compensation plan are deferrals that cannot be credited to our tax-qualified 401(k) plan because they exceed the annual contribution or compensation limits of that plan. Supplemental employee contributions in the deferred compensation plan are credited with a company-matching contribution using the same formula as in our 401(k) plan. The deferred compensation plan for directors allows them to defer receipt of a portion of their director and meeting fees until a later date. Directors participating in the plan select hypothetical investment funds for their deferrals and are credited with the hypothetical returns generated.
The awards, payments, deferrals and liabilities under the deferred compensation, annual and long-term incentive plans for officers and directors were as follows for the years ended December 31. The gross liabilities are presented separately in the Consolidated Statements of Financial Position, while allocations to affiliates are included in
reinsurance recoverable from Erie Insurance Exchange on unpaid losses and loss adjustment expenses until such time as payments are made to participants under the plan.
We have a stock compensation plan for our outside directors to further align the interests of directors with shareholders by providing for a portion of annual compensation for the directors’ services 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 director’s account with additional shares of our Class A common stock. In 2008, compensation expense for this plan was offset by market value adjustments to the director’s accounts resulting in a net credit of $0.2 million. In 2007 and 2006, the annual charge related to this plan totaled $0.4 million and $0.3 million, respectively.
A deferred tax asset valuation allowance of $1.3 million was recorded for 2008 related to impairments on investments where the related deferred tax asset is not expected to be realized.
We have one income tax position that would be considered uncertain under FIN 48, “Accounting for Uncertainty in Income Taxes,” for which a liability for current income taxes payable and a temporary tax difference were recognized, that when considered net, had no impact on our financial position. We recognize interest related to our remaining uncertain tax position in income tax expense. We have $0.4 million accrued for the estimated interest on
our unrecognized tax benefit at December 31, 2008 and 2007. The IRS has examined tax filings through 2004 and is currently examining our federal income tax returns for 2005. We do not currently estimate that our unrecognized tax benefits will change significantly in the next 12 months.
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 for each Class B share. There were no conversions of Class B shares to Class A shares in 2008. In 2007, 22 Class B shares were converted to 52,800 Class A shares, of which 20 of the Class B shares converted were part of a $99.0 million repurchase of 1.9 million shares from the F. William Hirt Estate. F. William Hirt, former Chairman of the Board of the Company, passed away in July 2007. The Hirt repurchase was authorized by the Board of Directors separate from the current repurchase plan.
EIC, EIPC, Flagship and EINY each have an intercompany reinsurance pooling agreement with the Exchange, whereby these companies cede all of their direct property/casualty insurance to the Exchange. EIC and EINY then assume 5% and 0.5%, respectively, of the total business pooled in the Exchange (including the business assumed from EIC and EINY) under this pooling agreement. This arrangement is approved by the Board of Directors. The pooling percentages were last modified in 1995. Intercompany accounts are settled by payment within 30 days after the end of each quarterly accounting period. The purpose of the pooling agreement is to spread the risks of the members of the Property and Casualty Group collectively across the different lines of business they underwrite and
We make certain payments for the account of the Group’s related entities. Cash transfers are settled quarterly. The amounts of these cash settlements made for the account of related entities were as follows for the years ended December 31:
We are 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 6.70% and will be payable on demand on or after December 31, 2018, with interest scheduled to be paid semi-annually. EFL paid interest to us of $1.7 million in 2008, 2007 and 2006.
We have a receivable due from the Exchange for reinsurance recoverable from unpaid losses and loss adjustment expenses and unearned premium balances ceded under the intercompany pooling arrangement totaling $887.4 million and $944.1 million at December 31, 2008 and 2007, respectively. Management fee and expense allocation amounts due from the Exchange were $214.3 million and $204.6 million at December 31, 2008 and 2007, respectively. The receivable from EFL for expense allocations totaled $3.9 million at December 31, 2008, compared to $4.2 million at December 31, 2007.
We hold a variable interest in the Exchange because of the absence of decision-making capabilities by the equity owners (subscribers) of the Exchange; however, we do not qualify as the primary beneficiary under Financial Accounting Standards Interpretation 46(R), “Consolidation of Variable Interest Entities.” Our consolidation conclusion has not changed from December 31, 2007.
The Exchange is a reciprocal insurer domiciled in the Commonwealth of Pennsylvania that underwrites a broad line of personal and commercial business, including private passenger auto, homeowners and commercial multi-peril insurance. Annual direct written premiums of the Exchange totaled $3.1 billion in 2008, 2007 and 2006. These premiums, along with investment income are the major sources of cash that support the operations of the Exchange. Policyholders’ surplus was $4.0 billion, $4.8 billion and $4.1 billion at December 31, 2008, 2007 and 2006, respectively.
We have not provided financial or other support to the Exchange for the reporting periods presented, that we were not previously contractually required to provide. At December 31, 2008, there are no explicit arrangements that would require us to provide future support to the Exchange.
We have no obligation related to any underwriting and/or investment losses experienced by the Exchange. We 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 we receive and the underwriting results of the Property and Casualty Group in which we have a 5.5% participation. In addition, a decline in the surplus of the Exchange from its current level would make it more likely that the management fee rate received by us would be reduced. See also the risk factors relating to the business of the Property and Casualty Group in Item 1A. “Risk Factors”.
The Exchange has contractual commitments to invest up to $655.8 million related to its limited partnership investments at December 31, 2008. These commitments will be funded as required by the partnerships’ agreements which principally expire in 2014. At December 31, 2008, the total remaining commitment to fund limited partnerships that invest in private equity securities was $312.4 million, real estate activities was $235.5 million and mezzanine debt securities was $107.9 million.
The financial statements of the Exchange are prepared in accordance with statutory accounting principles (SAP) prescribed by the Commonwealth of Pennsylvania. The Exchange is not required to prepare financial statements in accordance with generally accepted accounting principles (GAAP). Financial statements prepared under statutory accounting principles focus on the solvency of the insurer and generally provide a more conservative approach than under GAAP. Differences between SAP and GAAP include the valuation of investments, deferred policy acquisition cost assets, deferred tax assets, assets for estimated salvage and subrogation recoveries and unearned subscriber fees. Fixed maturities investments are carried at amortized cost and subject to impairment accounting. At December 31, 2008, the market value of fixed maturities was $216.9 million less than the carrying cost. Equity securities are carried at market value.
Accounting principles used to prepare statutory financial statements differ from those used to prepare financial statements under U.S. GAAP. The statutory financial statements of EIPC and EIC are prepared in accordance with accounting practices prescribed by the Pennsylvania Insurance Department. EINY prepares its statutory financial statements in accordance with accounting practices prescribed by the New York Insurance Department. Prescribed SAP include state laws, regulations, and general administration rules, as well as a variety of publications from the NAIC.
The minimum statutory capital and surplus requirements under Pennsylvania and New York law for our stock property/casualty subsidiaries amounts to $10.0 million. Our subsidiaries’ total statutory capital and surplus significantly exceed these minimum requirements, totaling $239.3 million at December 31, 2008. Our subsidiaries’ risk-based capital levels significantly exceed the minimum requirements.
The amount of dividends our Pennsylvania-domiciled property/casualty subsidiaries, EIC and EIPC, can pay without the prior approval of the Pennsylvania Insurance Commissioner is limited by Pennsylvania regulation to not more than the greater of: (a) 10% of its statutory surplus as reported on its last annual statement, or (b) the net income as reported on its last annual statement. The amount of dividends that the Erie Insurance Company’s New York-domiciled property/casualty subsidiary, EINY, can pay without the prior approval of the New York Superintendent of Insurance is limited to the lesser of: (a) 10% of its statutory surplus as reported on its last annual statement, or (b) 100% of its adjusted net investment income during such period. In 2009, the maximum dividend we could receive from our property/casualty insurance subsidiaries would be $23.0 million. No dividends were paid to us by our property/casualty insurance subsidiaries in 2008, 2007 or 2006.
The amount of dividends EFL, a Pennsylvania-domiciled life insurer, can pay to its shareholders without the prior approval of the Pennsylvania Insurance Commissioner is limited by statute to the greater of: (a) 10% of its statutory surplus as shown on its last annual statement on file with the commissioner, or (b) the net income as reported on its last annual statement, but shall not include pro-rata distribution of any class of the insurer’s own securities. Accordingly, our share of the maximum dividend payout which may be made in 2009 without prior Pennsylvania Commissioner approval is $2.2 million. There were no dividends paid to us in 2008.
We have contractual commitments to invest up to $90.8 million related to our limited partnership investments at December 31, 2008. These commitments will be funded as required by the partnerships’ agreements which principally expire in 2014. At December 31, 2008, the total remaining commitment to fund limited partnerships that invest in private equity securities is $41.8 million, real estate activities is $31.2 million and mezzanine debt securities is $17.8 million.
*The cumulative sum of quarterly basic and diluted net income per share amounts may not equal total basic and diluted net income per share for the year due to differences in weighted average shares and equivalent shares outstanding for each of the periods presented.
Fourth quarter income tax provision was impacted by adjustments to the tax basis of certain limited partnership investments that increased income taxes.