Indemnity and the Exchange share a corporate home office complex in Erie, Pennsylvania, which comprises approximately 996,000 square feet. Our square footage increased as the construction of the new office building was completed in the fourth quarter of 2020. Additionally, we lease two office buildings and one warehouse facility from third parties. We are charged rent for the related square footage we occupy.
Due to the uncertainty of the COVID-19 pandemic, approximately 90% of our workforce has been working remote since March 2020. We expect to return to our offices when conditions are feasible and safe.
Statements contained herein that are not historical fact are forward-looking statements and, as such, are subject to risks and uncertainties that could cause actual events and results to differ, perhaps materially, from those discussed herein. Forward-looking statements relate to future trends, events or results and include, without limitation, statements and assumptions on which such statements are based that are related to our plans, strategies, objectives, expectations, intentions, and adequacy of resources. Examples of forward-looking statements are discussions relating to premium and investment income, expenses, operating results, and compliance with contractual and regulatory requirements. Forward-looking statements are not guarantees of future performance and involve risks and uncertainties that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in such forward-looking statements. Among the risks and
•dependence upon our relationship with the Exchange and the growth of the Exchange, including:
•dependence upon our relationship with the Exchange and the financial condition of the Exchange, including:
◦factors affecting the quality and liquidity of the Exchange's investment portfolio;
•factors affecting the quality and liquidity of our investment portfolio; and
See Item 8. "Financial Statements and Supplementary Data - Note 2, Significant Accounting Policies, of Notes to Financial Statements" contained within this report for a discussion of recently adopted accounting standards and the impact on our financial statements.
We are a Pennsylvania business corporation that since 1925 has been the managing attorney-in-fact for the subscribers (policyholders) at the Exchange, a reciprocal insurer that writes property and casualty insurance. Our primary function as attorney-in-fact is to perform policy issuance and renewal services on behalf of the subscribers at the Exchange. We also act as attorney-in-fact on behalf of the Exchange, as well as the service provider for its insurance subsidiaries, with respect to all administrative services.
Pursuant to the subscriber’s agreement for acting as attorney-in-fact in these two capacities, we earn a management fee. Management fee revenue is based upon all direct and affiliated assumed premiums written by the Exchange and the management fee rate, which is not to exceed 25%. Our Board of Directors establishes the management fee rate at least annually, generally in December for the following year. The process of setting the management fee rate includes the evaluation of current year operating results compared to both prior year and industry estimated results for both Indemnity and the Exchange, and consideration of several factors for both entities including: their relative financial strength and capital position; projected revenue, expense and earnings for the subsequent year; future capital needs; as well as competitive position. The management fee rate was set at 25% for 2020, 2019 and 2018. Our Board of Directors set the 2021 management fee rate again at 25%, its maximum level.
Our earnings are primarily driven by the management fee revenue generated for the services we provide to the Exchange. The policy issuance and renewal services we provide to the Exchange are related to the sales, underwriting and issuance of policies. The sales related services we provide include agent compensation and certain sales and advertising support services. Agent compensation includes scheduled commissions to agents based upon premiums written as well as additional commissions and bonuses to agents, which are earned by achieving targeted measures. Agent compensation comprised approximately 66% of our 2020 policy issuance and renewal expenses. The underwriting services we provide include underwriting and policy processing and comprised approximately 10% of our 2020 policy issuance and renewal expenses. The remaining services we provide include customer service and administrative support. We also provide information technology services that support all the functions listed above that comprised approximately 11% of our 2020 policy issuance and renewal expenses. Included in these expenses are allocations of costs for departments that support these policy issuance and renewal functions.
On March 11, 2020, the outbreak of the coronavirus ("COVID-19") was declared a global pandemic. The significant volatility in the financial markets, economic disruption and uncertainty resulting from the COVID-19 pandemic that began in the first quarter of 2020 continues to evolve and the pandemic’s ultimate impact and duration remain highly uncertain at this time.
We have a dedicated internal committee comprised of management from various finance disciplines reviewing our risk positions and emerging trends on an ongoing basis as circumstances are evolving. The committee is reviewing risk scenarios and performing stress tests, including the review of cash flow trends, liquidity requirements and other forms of risk quantification. This provides tools for management, as well as our Risk Committee of the Board of Directors, to assess risks and prioritize key issues.
While we were not required to close our physical locations under the state mandated closure of nonessential services, out of concern for the health and safety of our employees, over 90% of our workforce has been working remote since March 2020. We have had no significant interruption to our core business processes or systems to date. We have had no significant changes to our financial close or reporting processes or related internal controls, nor do we anticipate any significant future challenges at this time. We have a dedicated team developing a return to the office plan that will be implemented when it becomes feasible and safe.
Operating income $ 338,157 (5.4) % $ 357,339 3.8 % $ 344,343
Net income per share - diluted $ 5.61 (7.4) % $ 6.06 9.9 % $ 5.51
Operating income decreased in 2020 compared to 2019 as growth in operating expenses outpaced the growth in operating revenues. Management fee revenue is based upon the management fee rate we charge and the direct and affiliated assumed premiums written by the Exchange. The management fee rate was 25% for 2020, 2019, and 2018. The direct and affiliated assumed premiums written by the Exchange increased 1.7% to $7.6 billion in 2020 and 5.2% to $7.5 billion in 2019.
Cost of operations for policy issuance and renewal services increased 3.3% to $1.6 billion in 2020 primarily due to higher commissions driven by direct and affiliated assumed written premium growth, higher agent incentive compensation driven by lower automobile claims frequency experienced by the Exchange, and higher personnel costs. Cost of operations for policy issuance and renewal services increased 5.5% to $1.5 billion in 2019 driven primarily by higher commissions and higher investments in information technology, partially offset by lower agent and employee incentive costs related to less profitable growth on the property and casualty insurance business of the Exchange.
Unfavorable changes in economic conditions, including declining consumer confidence, inflation, high unemployment, and the threat of recession, among others, may lead the Exchange’s customers to modify coverage, not renew policies, or even cancel policies, which could adversely affect the premium revenue of the Exchange, and consequently our management fee. The extent to which economic conditions could impact the Exchange’s operations and our management fee was exacerbated with the COVID-19 pandemic. The extent and duration of the impacts to economic conditions remain uncertain as the pandemic continues to evolve. See Financial Condition, Liquidity and Capital Resources, and Part I, Item 1A. "Risk Factors" contained within this report for a discussion of the potential impacts of the COVID-19 pandemic on our operations.
•An active market is one in which transactions for the assets being valued occur with sufficient frequency and volume to provide reliable pricing information.
•Level 1 - Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity can access at the measurement date.
•Level 2 - Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.
Level 2 includes those financial instruments that are valued using industry-standard models that consider various inputs, such as the interest rate and credit spread for the underlying financial instruments. All significant inputs are observable, or derived from observable information in the marketplace, or are supported by observable levels at which transactions are executed in the marketplace. Financial instruments in this category primarily include corporate bonds, structured securities and preferred stock.
illiquid nature of the market for these securities and represent the best estimate of the fair value that would occur in an orderly transaction between willing market participants at the measurement date under current market conditions. Fair value for these securities is generally valued using an estimate of fair value based upon indicative market prices that include significant unobservable inputs not based upon, nor corroborated by, market information, including the utilization of discounted cash flow analyses which have been risk-adjusted to take into account illiquidity and other market factors. This category primarily consists of structured securities and corporate bonds.
Available-for-sale securities in an unrealized loss position are evaluated to determine whether the impairment is a result of credit loss or other factors. If we have the intent to sell or it's more likely than not that we would be required to sell the security before recovery of the amortized cost basis, the entire impairment is recognized in earnings. Securities that have experienced a decline in fair value that we do not intend to sell, and that we will not be required to sell before recovery, are evaluated to determine if the decline in fair value is credit related. Impairment resulting from a credit loss is recognized in earnings with a corresponding allowance on the balance sheet. Future recoveries of credit loss result in an adjustment to the allowance and earnings in the period the credit conditions improve. Factors considered in the evaluation of credit loss include the extent to which fair value is less than cost and fundamental factors specific to the issuer such as financial condition, changes in credit ratings, near and long-term business prospects and other factors, as well as the likelihood of recovery of the amortized cost of the security. If the qualitative review indicates credit impairment, the allowance for credit loss is measured as the amount that the security’s amortized cost exceeds the present value of cash flows expected to be collected and is limited to the amount that fair value is below amortized cost.
We expect our net pension benefit costs to increase from $45.1 million in 2020 to $56.6 million in 2021 primarily driven by the decrease in the discount rate. Our share of the net pension benefit costs after reimbursements was $18.5 million in 2020. We expect our share of the net pension benefit costs to be approximately $23.2 million in 2021.
(1) Management fees are returned to the Exchange when policies are cancelled mid-term and unearned premiums are refunded. We record an estimated allowance for management fees returned on mid-term policy cancellations. This estimated allowance has been allocated between the two performance obligations consistent with the revenue allocation proportion. The potential for a greater number of mid-term cancellations as a result of the COVID-19 pandemic was taken into consideration in the determination of this allowance in 2020.
Premiums generated from renewal business increased 2.1% to $6.8 billion in 2020, compared to 6.4%, or $6.6 billion, in 2019. Underlying the trend in renewal business premiums were increases in average premium per policy and steady policy retention ratios. The renewal business year-over-year average premium per policy increased 0.4% at December 31, 2020, compared to 2.9% at December 31, 2019.
The Exchange implements rate changes in order to meet loss cost expectations. As the Exchange writes policies with annual terms only, rate actions take 12 months to be fully recognized in written premium and 24 months to be recognized 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 increased or decreased premiums in full. As a result, certain rate changes approved in 2019 were reflected in 2020, and a portion of the rate actions in 2020, primarily those in response to reduced driving conditions resulting from the COVID-19 pandemic, will be reflected in 2021. The Exchange continuously evaluates pricing and product offerings to meet consumer demands.
Changes in premium levels attributable to the growth in policies in force directly affect the profitability of the Exchange and have a direct bearing on our management fee. Our continued focus on underwriting discipline and the maturing of pricing sophistication models have contributed to the Exchange's steady policy retention ratios. The continued growth of its policy base is dependent upon the Exchange's ability to retain existing and attract new subscribers/policyholders. A lack of new policy growth or the inability to retain existing customers could have an adverse effect on the Exchange's premium level growth, and consequently our management fee.
The extent of the impact to the Exchange's premiums and our management fee cannot be estimated with a high degree of certainty at this time given the ongoing developments related to this pandemic. See also Part I, Item 1A. "Risk Factors" contained within this report.
Non-commission expense - Non-commission expense increased $24.3 million in 2020 compared to 2019. Underwriting and policy processing costs increased $5.7 million primarily due to increased personnel costs and underwriting report costs. Information technology costs increased $6.2 million primarily due to increased personnel costs and hardware and software costs. Administrative and other expenses increased $9.3 million primarily driven by increased personnel costs. Increased personnel costs in all categories included higher incentive plan award accruals related to underwriting performance in 2020
In 2019, non-commission expense increased $39.5 million compared to 2018. Underwriting and policy processing costs increased $5.7 million primarily due to increased underwriting report costs and other policy acquisition costs. Information technology costs increased $23.1 million primarily due to increased professional fees and hardware and software costs. Sales and advertising costs decreased $3.2 million due to decreased personnel costs. Customer service costs increased $2.9 million primarily due to increased credit card processing fees and personnel costs. Administrative and other expenses increased $11.1 million primarily driven by an increase in the long-term incentive plan costs due to a higher company stock price in 2019 compared to 2018 and several multi-year commitments made to support community development initiatives. Personnel costs in all expense categories were impacted by increased medical expenses, somewhat offset by lower estimated costs for incentive plans related to sales and underwriting performance in 2019 compared to targets.
Net investment income $ 29,753 (12.6) % $ 34,059 15.9 % $ 29,387
Net impairment losses recognized in earnings (3,278) NM (195) NM (1,581)
Net investment income primarily includes interest and dividends on our fixed maturity and equity security portfolios, net of investment expenses. Net investment income decreased by $4.3 million in 2020, compared to 2019, primarily due to decreased income from cash and cash equivalents driven by lower rates and invested balances, somewhat offset by increased preferred stock income resulting from higher invested balances. Net investment income increased by $4.7 million in 2019, compared to 2018, primarily due to an increase in cash and cash equivalent and agent loan interest income reflecting higher invested balances and rates, somewhat offset by decreased income on fixed maturities due to lower invested balances and yields.
Net realized gains of $6.4 million in 2020 were primarily due market value adjustments on equity securities and from the sale of available-for-sale securities. Net realized gains of $6.1 million in 2019 were primarily due to gains from sales of available-for-sale securities and increases in fair value of equity securities, while losses of $2.0 million in 2018 were due to losses from sales of available-for-sale and equity securities and decreases in fair value of equity securities.
Net impairment losses recognized on available-for-sale securities in 2020 include $2.3 million of securities in an unrealized loss position where we had intent to sell prior to recovery of our amortized cost basis and $0.7 million of credit impairment losses. The remaining impairments include the change in the current expected credit loss allowance related to our agent loans. The COVID-19 pandemic's impact on financial markets contributed to higher impairment losses on our available-for-sale securities during 2020 compared to prior years. Net impairment losses recognized in 2019 and 2018 included securities in an unrealized loss position that we intended to sell prior to expected recovery of our amortized cost basis as well as securities in an unrealized loss position where we determined the loss was other-than-temporary based on credit factors.
Fixed maturities are carried at fair value with unrealized gains and losses, net of deferred taxes, included in shareholders' equity. Net unrealized gains on fixed maturities, net of deferred taxes, totaled $23.3 million at December 31, 2020, compared to net unrealized gains of $4.5 million at December 31, 2019.
The following table presents an analysis of the fair value of our nonredeemable preferred and common stock securities by sector as of December 31:
While we did not see a significant impact on our sources or uses of cash in 2020 as a result of the COVID-19 pandemic, we may experience future reductions in our management fee revenue if the Exchange’s premium growth is constrained. Also, future disruptions in the markets could occur which may affect our liquidity position. Accordingly, we continue to monitor the sufficiency of our liquidity and capital resources given the potential impact of the COVID-19 pandemic. There is potential that the funding requirements for our costs of operations will increase related to agent compensation and technology costs, among others. If our normal operating and investing cash activities were to become insufficient to meet future funding requirements, we believe we have sufficient access to liquidity through our cash position, liquid marketable securities and our $100 million line of credit that does not expire until October 2023. See broader discussions of potential risks to our operations in the Operating Overview and Part I, Item 1A. "Risk Factors" contained within this report.
Net cash used in financing activities totaled $274.9 million in 2020, compared to $169.6 million in 2019 and $131.5 million in 2018. The increase in cash used in 2020, compared to 2019, was due to an increase in dividends paid to shareholders. In
addition to the normal quarterly dividends paid in 2020, the Board also declared a special one-time cash dividend of $2.00 on each Class A share and $300 on each Class B share totaling $93.1 million, which was paid in December 2020. The increase in cash used in 2019, compared to 2018, was due to an increase in dividends paid to shareholders and principal payments on the senior secured draw term loan credit facility, which commenced January 1, 2019.
We purchase shares of our outstanding Class A nonvoting common stock outside of our publicly announced share repurchase program for certain stock-based incentive plans. We purchased 31,248 shares for $5.8 million in 2020, 15,003 shares for $2.6 million in 2019 and 27,120 shares for $3.2 million in 2018 to settle awards for our equity compensation plan and to fund the rabbi trust for the outside director deferred stock compensation plan and the incentive compensation deferral plan. All shares were delivered in the year they were purchased.
We regularly prepare forecasts evaluating the current and future cash requirements for both normal and extreme risk events, including the current COVID-19 pandemic. Should an extreme risk event result in a cash requirement exceeding normal cash flows, we have the ability to meet our future funding requirements through various alternatives available to us.
(3) Operating leases represent the total commitment for the lease components of our operating lease agreements. Non-lease component commitments related to these contracts are included in other commitments. See Item 8. "Financial Statements and Supplementary Data - Note 2, Significant Accounting Policies and Note 8, Leases, of Notes to Financial Statements" contained within this report.
as discussed previously. These receivables from the Exchange and its affiliates are settled monthly. We continually monitor the financial strength of the Exchange.
We have audited the accompanying statements of financial position of Erie Indemnity Company (the "Company") as of December 31, 2020 and 2019, the related statements of operations, comprehensive income, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2020, and the related notes (collectively referred to as the "financial statements"). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 25, 2021 expressed an unqualified opinion thereon.
Description of the Matter For the year ended December 31, 2020, the Company’s administrative services reimbursement revenue totaled $609.4 million. The Company’s primary function, as attorney-in-fact, is to perform certain services on behalf of the subscribers at the Erie Insurance Exchange (Exchange) and its insurance subsidiaries, in accordance with the Subscriber’s Agreement and the service agreements with each of the Exchange’s insurance subsidiaries. As explained in Note 2 of the financial statements, pursuant to approved service agreements, administrative services, which include costs associated with claims handling services, life insurance related operating activities, investment management, and operating overhead incurred by the Company on behalf of the Exchange and its insurance subsidiaries, are reimbursed to the Company at cost and recorded as administrative services reimbursement revenue. To determine the proportional cost allocation to each entity, the Company determines utilization statistics using numerous variables including, among others, employee count, square footage, vehicle count, and project hours.
To test the Company’s proportional cost allocations, our procedures included, among others, evaluating that the costs included in the allocations are in accordance with the Subscriber’s Agreement and the service agreements with each of the Exchange’s insurance subsidiaries. We tested the completeness and accuracy of the costs subjected to allocation through testing of the reconciliation of the costs recorded in the source systems to the costs that are allocated. We evaluated the allocation of costs to the Exchange and its insurance subsidiaries with the costs allocated in prior periods.
Cost of operations - policy issuance and renewal services 1,588,897 1,537,949 1,457,533
Class B common stock - basic and diluted $ 945 $ 1,020 $ 928
Balance, December 31, 2017 $ 1,992 $ 178 $ 16,470 $ (156,059) $ 2,140,853 $ (1,155,668) $ 9,578 $ 857,344
Balance, December 31, 2018 $ 1,992 $ 178 $ 16,459 $ (130,284) $ 2,231,417 $ (1,157,625) $ 11,535 $ 973,672
Balance, December 31, 2019 $ 1,992 $ 178 $ 16,483 $ (116,868) $ 2,377,558 $ (1,158,910) $ 12,820 $ 1,133,253
(1) Cumulative effect adjustments in 2018 are primarily related to the implementation of new revenue recognition guidance effective January 1, 2018. The Cumulative effect adjustment in 2020 is related to the implementation of new credit loss allowance accounting guidance effective January 1, 2020. See Note 2, "Significant Accounting Policies."
(3) Distributions of our Class A shares were made from the rabbi trust to a retired director and an incentive compensation deferral plan participant in 2018, 2019 and 2020. See Note 11, "Incentive and Deferred Compensation Plans".
Repayment of note receivable from Erie Family Life Insurance - - 25,000
The policy issuance and renewal services we provide to the Exchange are related to the sales, underwriting and issuance of policies. The sales related services we provide include agent compensation and certain sales and advertising support services. Agent compensation includes scheduled commissions to agents based upon premiums written as well as additional commissions and bonuses to agents, which are earned by achieving targeted measures. Agent compensation comprised approximately 66% of our 2020 policy issuance and renewal expenses. The underwriting services we provide include underwriting and policy processing and comprised approximately 10% of our 2020 policy issuance and renewal expenses. The remaining services we provide include customer service and administrative support. We also provide information technology services that support all the functions listed above that comprised approximately 11% of our 2020 policy issuance and renewal expenses. Included in these expenses are allocations of costs for departments that support these policy issuance and renewal functions.
The economic conditions resulting from the COVID-19 pandemic may negatively impact the collectability of the Exchange’s premiums receivable, however no significant impact has been noted through the date of this report. While our investment portfolio was negatively impacted by the volatility in the financial markets in the first quarter of 2020, markets substantially recovered through the remainder of 2020. We are unable to predict the duration or extent of the business disruption or the financial impact given the ongoing development of the pandemic and its impacts on the economy and financial markets.
The accompanying financial statements have been prepared in conformity with U.S. generally accepted accounting principles ("GAAP").
We adopted Accounting Standards Update ("ASU") 2016-13, "Financial Instruments-Credit Losses" which applies to our receivable from Erie Insurance Exchange and affiliates, agent loans, and investments, on January 1, 2020. The guidance requires financial assets measured at amortized cost to be presented at the net amount expected to be collected through the use of a new forward-looking current expected credit loss model and credit losses relating to available-for-sale debt securities to be recognized through an allowance for credit losses.
For assets measured at amortized cost for which a current expected credit loss allowance was required, we adopted the guidance using the modified-retrospective approach. At January 1, 2020, we recorded current expected credit loss allowances related to agent loans of $0.8 million and receivables from Erie Insurance Exchange and affiliates of $0.6 million. This resulted in the recording of a cumulative effect adjustment, net of taxes, to retained earnings of $1.1 million. Our available-for-sale investments are not measured at amortized cost, and therefore do not require the use of a current expected credit loss model. Any credit losses, however, are required to be recorded as an allowance for credit losses rather than a reduction of the carrying value of the asset. For available-for-sale securities, we adopted the guidance using the prospective approach and recorded an initial allowance for credit losses of $0.6 million at March 31, 2020.
We adopted Accounting Standards Codification ("ASC") 842, "Leases" on January 1, 2019 using the optional transition method, which permits entities to apply the new guidance prospectively with certain practical expedients available. We elected the package of practical expedients which among other things allowed us to carry forward the historical lease classifications. We did not elect the hindsight practical expedient in determining the lease term for existing leases. The adoption of the new standard resulted in the recognition of operating lease assets of $32.7 million and operating lease liabilities of $32.1 million on the Statement of Financial Position at January 1, 2019. The adoption of this standard did not have a material impact on our Statement of Operations and had no impact on our net cash flows.
On January 1, 2018, we established a contract liability of $48.5 million representing the portion of revenue not yet earned related to the administrative services to be provided in subsequent years. We recorded a related deferred tax asset of $10.2 million and a cumulative effect adjustment that reduced retained earnings by $38.3 million. The adoption of ASC 606 changed the presentation of our Statement of Cash Flows, but had no net impact to our cash flows.
Equity securities - Non-redeemable preferred and common stocks are classified as equity securities and reported at fair value with changes in fair value recognized in net realized investment gains (losses). Securities that we intend to sell as of the reporting date are classified as current assets.
Realized gains and losses and investment income - Realized gains and losses on sales of available-for-sale and equity securities are recognized in income based upon the specific identification method and reported as net realized investment gains (losses). Interest income is recognized as earned and includes amortization of premium and accretion of discount. Income is recognized based on the constant effective yield method, which includes periodically updated prepayment assumptions obtained from third party data sources on our prepaying securities. The effective yield for prepaying securities is recalculated on a retrospective basis. Dividend income is recognized at the ex-dividend date. Interest and dividend income and the results of our limited partnership investments are reported as net investment income. We do not record an allowance for credit losses on accrued investment income as any amount deemed uncollectible is reversed from interest income in the period the expected payment defaults.
Agent loans, the majority of which are senior secured, are carried at unpaid principal balance with interest recorded in investment income as earned. The current portion of agent loans is recorded in prepaid expenses and other current assets. The adoption of ASU 2016-13 on January 1, 2020 requires the recording of a current expected credit loss allowance on these loans. The allowance is estimated using available loss history and/or external loss rates based on comparable loan losses and considers current conditions and forecasted information. When establishing the expected credit loss allowance upon implementation of ASU 2016-13, a cumulative effect adjustment was recorded to beginning retained earnings. Future changes to the allowance
will be recognized in earnings as adjustments to net impairment losses. Prior to the adoption of ASU 2016-13, we did not record an allowance for credit losses as the majority of these loans are senior secured and have had insignificant default amounts.
By virtue of its legal structure as a reciprocal insurer, the Exchange does not have any employees or officers. Therefore, it enters into contractual relationships by and through an attorney-in-fact. Indemnity serves as the attorney-in-fact on behalf of the Exchange with respect to its administrative services in accordance with the subscriber's agreement. The Exchange's insurance subsidiaries also utilize Indemnity for these services in accordance with the service agreements between each of the subsidiaries and Indemnity. Claims handling services include costs incurred in the claims process, including the adjustment, investigation, defense, recording and payment functions. Life insurance management services include costs incurred in the management and processing of life insurance business. Investment management services are related to investment trading activity, accounting and all other functions attributable to the investment of funds. Included in these expenses are allocations of costs for departments that support these administrative functions. Common overhead expenses and certain service department costs incurred by us on behalf of the Exchange and its insurance subsidiaries are reimbursed by the proper entity based upon appropriate utilization statistics (employee count, square footage, vehicle count, project hours, etc.) specifically measured to accomplish proportional allocations, which we believe are reasonable. The expenses we incur and related reimbursements we receive for administrative services are presented gross in our Statement of Operations. Reimbursements are settled on a monthly basis. The amounts incurred for these services are reimbursed to Indemnity at cost in accordance with the subscriber's
agreement and the service agreements. State insurance regulations require that intercompany service agreements and any material amendments be approved in advance by the state insurance department.
The majority of our revenue is derived from the subscriber’s agreement between us and the subscribers (policyholders) at the Exchange. Pursuant to the subscriber’s agreement, we earn a management fee calculated as a percentage, not to exceed 25%, of all direct and affiliated assumed written premiums of the Exchange.
We allocate a portion of our management fee revenue, currently 25% of the direct and affiliated assumed written premiums of the Exchange, between the two performance obligations we have under the subscriber’s agreement. The first performance obligation is to provide policy issuance and renewal services to the subscribers (policyholders) at the Exchange, and the second is to act as attorney-in-fact on behalf of the Exchange, as well as the service provider for its insurance subsidiaries, with respect to all administrative services. The transaction price, including management fee revenue and administrative service reimbursement revenue, is allocated based on the estimated standalone selling prices developed using industry information and other available information for similar services. We update the transaction price allocation annually based upon the most recent information available or more frequently if there have been significant changes in any components considered in the transaction price. In 2020, we reviewed the transaction price allocation quarterly to consider the most current economic conditions related to the COVID-19 pandemic. The reviews resulted in no material change to the allocation.
The Exchange, by virtue of its legal structure as a reciprocal insurer, does not have any employees or officers. Therefore, it enters into contractual relationships by and through an attorney-in-fact. Indemnity serves as the attorney-in-fact on behalf of the Exchange with respect to its administrative services in accordance with the subscriber's agreement. The Exchange's insurance subsidiaries also utilize Indemnity for these services in accordance with the service agreements between each of the subsidiaries and Indemnity. Collectively, these services represent a second performance obligation under the subscriber’s agreement and the service agreements. The revenue allocated to this performance obligation is recognized over time as these services are provided. The portion of revenue not yet earned is recorded as a contract liability in the Statements of Financial Position. The administrative services expenses we incur and the related reimbursements we receive are recorded gross in the Statements of Operations.
Valuation techniques used to derive the fair value of our available-for-sale and equity securities are based upon observable and unobservable inputs. Observable inputs reflect market data obtained from independent sources. Unobservable inputs reflect our own assumptions regarding fair market value for these securities. Financial instruments are categorized based upon the following characteristics or inputs to the valuation techniques:
The following tables present our fair value measurements on a recurring basis by asset class and level of input as of:
We review the fair value hierarchy classifications each reporting period. Transfers between hierarchy levels may occur due to changes in available market observable inputs.
Corporate debt securities $ 8,324 $ (2) $ (156) $ 7,180 $ (1,405) $ 10,526 $ (18,642) $ 5,825
Residential mortgage-backed securities 0 (19) (48) 287 (1,539) 11,496 (9,240) 937
Commercial mortgage-backed securities 3,321 (183) 913 12,281 (2,334) 39,591 (34,127) 19,462
Collateralized debt obligations 0 0 3 247 0 0 (250) 0
Total Level 3 securities $ 11,645 $ (53) $ 712 $ 22,831 $ (5,278) $ 61,613 $ (65,246) $ 26,224
Collateralized debt obligations 0 0 1 2,300 0 0 (2,301) 0
(2) Transfers into and/or (out) of Level 3 are primarily attributable to the availability of market observable information and the re-evaluation of the observability of pricing inputs.
(1)The discount rate used to calculate fair value at December 31, 2020 is reflective of an increase in the BB+ financial yield curve due to the market volatility resulting from the COVID-19 pandemic.
(2)The discount rate used to calculate fair value at December 31, 2020 is reflective of a decline in U.S. Treasury bond yields due to the market volatility resulting from the COVID-19 pandemic.
See Note 5, "Fair Value" for additional fair value disclosures. The following tables summarize the cost and fair value, net of credit loss allowance, of our available-for-sale securities as of:
Total available-for-sale securities, net $ 898,790 $ 31,569 $ 2,123 $ 928,236
Total available-for-sale securities, net $ 724,950 $ 7,939 $ 2,188 $ 730,701
(1)The contractual maturities of our available-for-sale securities are included in the table. However, given our intent to sell certain impaired securities, these securities are classified as current assets in our Statements of Financial Position at December 31, 2020.
Corporate debt securities $ 39,693 $ 644 $ 7,952 $ 870 $ 47,645 $ 1,514 257
Investment grade $ 86,807 $ 561 $ 10,899 $ 99 $ 97,706 $ 660 119
Total available-for-sale securities $ 115,493 $ 1,154 $ 18,851 $ 969 $ 134,344 $ 2,123 370
Investment grade $ 76,315 $ 287 $ 46,390 $ 218 $ 122,705 $ 505 100
Total available-for-sale securities $ 87,736 $ 611 $ 57,081 $ 1,577 $ 144,817 $ 2,188 246
The portion of net unrealized gains and losses recognized during the reporting period related to equity securities held at the reporting date is calculated as follows for the years ended December 31:
Upon adoption of ASU 2016-13 on January 1, 2020, impairments on available-for-sale securities that are deemed to be credit related are recognized in earnings with a corresponding available-for-sale security allowance. All unrealized losses related to factors other than credit are recorded in other comprehensive income. Prior to January 1, 2020, we had the intent to sell all credit-impaired available-for-sale securities; therefore, the entire amount of the impairment charges was included in earnings and no impairments were recognized in other comprehensive income. See also Note 2, "Significant Accounting Policies".
Land, buildings, and building improvements, equipment, and furniture and fixtures increased due to the completion of a new office building serving as part of our principal headquarters in the fourth quarter of 2020. The building was financed using a senior secured draw term loan credit facility. See Note 9, "Borrowing Arrangements". Interest capitalized during construction was $3.5 million, $3.4 million, and $1.5 million for the years ended December 31, 2020, 2019 and 2018, respectively. Projects in progress include certain computer software and software developments costs for internal use that are not yet subject to amortization. Depreciation and amortization of fixed assets totaled $21.2 million, $16.8 million and $13.4 million for the years ended December 31, 2020, 2019 and 2018, respectively, and is included in cost of operations - policy issuance and renewal services.
The following table summarizes our lease assets and liabilities as of December 31:
In 2016, we entered into a credit agreement for a $100 million senior secured draw term loan credit facility ("Credit Facility") for the acquisition of real property and construction of an office building to serve as part of our principal headquarters. On January 1, 2019, the Credit Facility converted to a fully-amortized term loan with monthly payments of principal and interest at a fixed rate of 4.35% over a period of 28 years. Investments with a fair value of $126.5 million were pledged as collateral for the facility and are reported as available-for-sale securities and cash and cash equivalents as of December 31, 2020. The bank requires compliance with certain covenants, which include leverage ratios, debt restrictions and minimum net worth, for our Credit Facility. We are in compliance with all covenants at December 31, 2020.
The remaining unpaid balance from the Credit Facility is reported at carrying value, net of unamortized loan origination and commitment fees as long-term borrowings. See Note 5, "Fair Value" for the estimated fair value of these borrowings.
Service cost for benefits earned $ 43,492 $ 33,854 $ 38,052
(2) In 2020, the SERP discount rate methodology was revised to utilize SERP specific cash outflows independent of the employee pension plan discount rate, eliminating a difference between pre-retirement and post-retirement rates.
The SERP had accumulated benefit obligations in excess of plan assets at December 31:
Fair value of plan assets, beginning of year $ 907,625 $ 767,569
Net actuarial (gain) loss arising during the year $ (11,832) $ 3,626
U.S. equity securities 27 % (1) 27 % 28 % 28 %
(1) U.S. equity securities - 23% seek to achieve excess returns relative to the Russell 2000 Index. The remaining 77% of the allocation to U.S. equity securities are comprised of equity index funds that track the S&P 500.
The following tables present fair value measurements for the pension plan assets by major category and level of input as of:
U.S. equity securities $ 296,624 $ 0 $ 296,624 $ 0
The following table sets forth amounts of benefits expected to be paid over the next 10 years from our pension plans as of:
All full-time and regular part-time employees are eligible to participate in a qualified 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 $15.8 million in 2020, $14.9 million in 2019, and $13.9 million in 2018. In 2018, we made an additional discretionary employer contribution of $5.4 million, as a way of sharing the tax savings realized from the lower corporate income tax rate that became effective January 1, 2018 with our employees. The Exchange and its subsidiaries reimbursed us for approximately 59% of the matching and discretionary contributions. 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, provided they are in compliance with applicable insider trading laws; sales by executive and senior officers are subject to additional pre-clearance restrictions imposed by our insider trading policies. 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, 2020 and 2019.
The Exchange and its subsidiaries reimburse us for compensation costs of employees performing administrative services. Earned compensation costs are allocated to these entities and reimbursed to us in cash once the payout is made. The total compensation cost charged to operations related to these LTIP awards was $12.0 million in 2020, $7.3 million in 2019, and $6.3 million in 2018. The related tax benefits recognized in income were $2.5 million in 2020, $1.5 million in 2019, and $1.3 million in 2018. The Exchange and its subsidiaries reimburse us for approximately 48% of the annual compensation cost of these plans. At December 31, 2020, there was $6.8 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.
We have an unfunded, non-qualified incentive compensation deferral plan for participants of the AIP and LTIP. Participants can elect to defer up to 100% of their annual AIP award and/or up to 100% of their LTIP award for each performance period. Deferred awards will be credited to a deferred stock account as credits denominated in Class A shares of the Company stock until retirement or other separation from service from the Company. Participants are 100% vested at date of deferral. The shares are held in a rabbi trust, which was established to hold the shares earned under both the incentive compensation deferral plan and the deferred stock compensation plan for outside directors. The rabbi trust is classified and accounted for as equity in a manner consistent with the accounting for treasury stock. Dividends received on the shares in the rabbi trust are used to purchase additional shares. Vested share credits will be paid to participants from the rabbi trust upon separation from service in approximate equal annual installments of Class A shares for a period of three years. In 2020, the rabbi trust purchased 3,934 shares of our common stock in the open market at an average price of $155.92 for $0.6 million to satisfy the liability for the 2019 AIP awards and 18,126 shares at an average price of $185.31 for $3.4 million to satisfy the liability for the 2017-2019 LTIP performance period awards deferred under the incentive compensation deferral plan. In 2019, the rabbi trust purchased 4,387 shares of our common stock in the open market at an average price of $176.34 for $0.8 million to satisfy the liability for the 2018 AIP awards deferred under the incentive compensation deferral plan. In 2018, the rabbi trust purchased 12,005 shares of our common stock in the open market at an average price of $119.28 for $1.4 million to satisfy the liability for the 2017 AIP awards deferred under the incentive compensation deferral plan.
Deferred executive compensation, beginning of the year $ 24,616 $ 26,182 $ 30,057
Funding of rabbi trust for deferred stock compensation plan for outside directors (1,493) (1,434) (1,165)
Deferred executive compensation, end of the year $ 32,223 $ 24,616 $ 26,182
(1) Forfeitures are the result of a plan participant who separated from service with the Company.
We also have an equity compensation plan ("ECP") which is designed to reward key employees, as determined by the ECDC or the chief executive officer, who can have a significant impact on our long-term performance and to further align the interests of such employees with those of our shareholders. The ECP permits grants of restricted shares, restricted share units and other share based awards, to be satisfied with shares of our Class A common stock or cash. The ECDC determines the form of the award to be granted at the beginning of each performance period. The number of shares of the Company's Class A common stock authorized for grant under the ECP is 100,000 shares, with no one person able to receive more than 5,000 shares in a calendar year. We do not issue new shares of common stock to satisfy plan awards. Share awards are settled through the repurchase of our Class A common stock on the open market. 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. Dividend equivalents may provide for the crediting of interest or hypothetical reinvestment experience payable after expiration of the performance period. Vesting conditions are determined at the time the award is granted and may include continuation of employment for a specific period, satisfaction of performance goals and the defined performance period, and the satisfaction of any other terms and conditions as determined to be appropriate. The plan is to remain in effect until December 31, 2022, unless earlier amended or terminated by our Board of Directors.
To date, all awards have been satisfied with shares of our Class A common stock. In 2020, we purchased 1,787 Class A shares with an average share price of $165.82 and a market value of $0.3 million to satisfy the liability for the 2017 plan year. In 2019, we purchased 3,246 Class A shares with an average share price of $132.35 and a market value of $0.4 million to satisfy the liability for the 2016 plan year. In 2018, we purchased 5,830 shares with an average share price of $117.39 and a market value of $0.7 million to satisfy the liability for the 2015 plan year and remainder of the 2014 plan year awards. The total compensation charged to operations related to these ECP awards was $0.7 million in 2020, $0.5 million in 2019, and $0.4 million in 2018. The Exchange and its subsidiaries reimburse us for earned compensation costs of employees performing administrative services, which can fluctuate each year based on the plan participants. The Exchange and its subsidiaries reimbursed us for approximately 59%, 49%, and 68% of the awards paid in 2020, 2019, and 2018 respectively. Unearned compensation expense of $0.6 million is expected to be recognized over a period of three years.
Balance at the beginning of the year $ 0 $ 3,088 $ 0
The uncertain tax position including $3.1 million of tax expense and $0.9 million of interest expense recorded in 2018 was settled during 2019. This settlement reduced our effective tax rate by 1.0% in 2019. The amounts recorded in 2018 resulted from the difference in measuring the tax liability at the previous tax rate and the current enacted tax rate. The recording of the uncertain tax position and related interest expense increased our 2018 effective tax rate by 1.0%.
Tax years ending December 31, 2019, 2018 and 2017 remain open to IRS examination. We are not currently under IRS audit, nor have we been notified of an upcoming IRS audit.
We have two classes of common stock: Class A which has a dividend preference and Class B which has voting power and a conversion right. Each share of Class A common stock outstanding at the time of the declaration of any dividend upon shares of Class B common stock shall be entitled to a dividend payable at the same time, at the same record date, and in an amount at least equal to 2/3 of 1.0% of any dividend declared on each share of Class B common stock. We may declare and pay a dividend in respect to Class A common stock without any requirement that any dividend be declared and paid in respect to Class B common stock. Sole shareholder voting power is vested in Class B common stock except insofar as any applicable law shall permit Class A common shareholders to vote as a class in regards to any changes in the rights, preferences, and privileges attaching to Class A common stock. Holders of Class B shares may, at their option, convert their shares into Class A shares at the rate of 2,400 Class A shares per Class B share. There were no shares of Class B common stock converted into Class A common stock in 2020, 2019 or 2018.
Our Board of Directors authorized a stock repurchase program effective January 1, 1999 allowing the repurchase of our outstanding Class A nonvoting common stock. In 2011, our Board of Directors approved a continuation of the current stock repurchase program for a total of $150 million, with no time limitation. Treasury shares are recorded in the Statements of Financial Position at total cost based upon trade date. There were no shares repurchased under this program during 2020, 2019 or 2018. We had approximately $17.8 million of repurchase authority remaining under this program at December 31, 2020, based upon trade date.
OCI (loss) before reclassifications 22,074 4,636 17,438 19,257 4,044 15,213 (15,372) (3,228) (12,144)
Realized investment (gains) losses (1,335) (280) (1,055) (4,619) (970) (3,649) 1,297 272 1,025
Impairment losses 2,981 626 2,355 195 41 154 1,581 332 1,249
AOCI (loss), beginning of year $ (153,600) $ (32,257) $ (121,343) $ (155,749) $ (32,708) $ (123,041) $ (200,954) $ (42,201) $ (158,753)
OCI (loss) before reclassifications 11,832 2,485 9,347 (4,085) (858) (3,227) 31,401 6,594 24,807
AOCI (loss), end of year $ (128,300) $ (26,944) $ (101,356) $ (153,600) $ (32,257) $ (121,343) $ (155,749) $ (32,708) $ (123,041)
AOCI (loss), beginning of year $ (147,936) $ (31,068) $ (116,868) $ (164,918) $ (34,634) $ (130,284) $ (197,544) $ (41,485) $ (156,059)
AOCI (loss), end of year $ (98,916) $ (20,773) $ (78,143) $ (147,936) $ (31,068) $ (116,868) $ (164,918) $ (34,634) $ (130,284)
(1)A reclassification of unrealized losses of equity securities from AOCI (loss) to retained earnings was required at January 1, 2018 as a result of new accounting guidance.
(2)These components of AOCI (loss) are included in the computation of net periodic pension cost. See Note 10, "Postretirement Benefits", for additional information.
A management fee is charged to the Exchange for services we provide under the subscriber's agreement with subscribers at the Exchange. The fee is a percentage of direct and affiliated assumed premiums written by the Exchange. This percentage rate is determined at least annually by our Board of Directors but cannot exceed 25%. The management fee rate charged the Exchange was 25% in 2020, 2019 and 2018. The Board of Directors elected to maintain the fee at 25% beginning January 1, 2021.
We previously owned three field offices for which rental costs of shared facilities were allocated based upon usage or square footage occupied. In 2018, we sold the field offices we owned to the Exchange at the current independent appraised value in order to align the ownership interest of these facilities with the functions being performed at these locations, which are claims-related activities. We recognized a gain on the sale of $3.4 million, which is included in "Other (expense) income".
Financial instruments that could potentially expose us to concentrations of credit risk include our unsecured receivables from the Exchange. A large majority of our revenue and receivables are from the Exchange and its affiliates. See also Note 1, "Nature of Operations". Net management fee amounts and other reimbursements due from the Exchange and its affiliates were $494.6 million and $468.6 million at December 31, 2020 and 2019, respectively. Given the financial strength of the Exchange and historical experience of no credit losses, we previously did not record a credit loss allowance to these receivables. Upon adoption of ASU 2016-13, we recorded an allowance for current expected credit losses of $0.6 million related to the receivables from the Exchange and affiliates. See also Note 2, "Significant Accounting Policies". There was no material change to this allowance as of December 31, 2020.
(Increase) decrease in prepaid expenses and other assets (2,569) (9,407) 6,446
(Decrease) increase in accounts payable and accrued expenses (14,307) (3,627) 11,039