See Item 8. “Financial Statements and Supplementary Data - Note 2, Significant Accounting Policies, of Notes to Consolidated Financial Statements” contained within this report for a discussion of adopted and/or pending accounting pronouncements, none of which are expected to have a material impact on our future financial condition, results of operations or cash flows.
net investment income and results on investments that belong to the Exchange and its subsidiaries; and
The following table represents a breakdown of the composition of the income attributable to the Indemnity shareholder interest and the income attributable to the noncontrolling interest (Exchange). For purposes of this discussion, EFL’s investments are included in the life insurance operations(1).
Indemnity defines operating income as net income excluding realized capital gains and losses, impairment losses, and related federal income taxes.
The following table reconciles operating income and net income for the Indemnity shareholder interest for the years ended December 31(1):
Management operations generate internal management fee revenue, which accrues to the Indemnity shareholder interest, as Indemnity provides services relating to the sales, underwriting, and issuance of policies on behalf of the Exchange. Management fee revenue is based upon all premiums written or assumed 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, and considers factors such as the relative financial strength of Indemnity and the Exchange and projected revenue streams. The management fee rate was set at 25% for 2013, 2012 and 2011. Our Board of Directors set the 2014 management fee rate again at 25%, its maximum level. Management fee revenue is eliminated upon consolidation.
The property and casualty insurance operation’s premium growth strategy focuses on growth by expansion of existing operations including a careful agency selection process and increased market penetration in existing operating territories. Expanding the size of our existing agency force of over 2,150 independent agencies, with over 10,550 licensed property and casualty representatives, will contribute to future growth as new agents build their books of business with the Property and Casualty Group.
Geographic expansion is also a component of the Property and Casualty Group's premium growth strategy. The Property and Casualty Group plans to expand operations into the Commonwealth of Kentucky by the first quarter of 2015 or earlier if possible.
The property and casualty insurance operations insure preferred and standard risks while maintaining a disciplined underwriting approach. The Property and Casualty Group’s principal personal lines products based upon 2013 direct written premiums were private passenger automobile (44%) and homeowners (26%), and the principal commercial lines products were commercial multi-peril (13%), commercial automobile (7%), and workers compensation (7%). Pennsylvania, Maryland, Virginia, North Carolina and Ohio made up 75% of the property and casualty lines insurance business direct written premium in 2013.
Earnings on life insurance related invested assets are integral to the evaluation of the life insurance operations because of the long duration of life products. On that basis, for presentation purposes, the life insurance operations segment discussion includes the life insurance related investment results. However, also for presentation purposes, the segment footnote and the investment operations segment discussion also include the life insurance investment results as part of the Exchange’s investment results.
We generate revenues from our fixed maturity, equity security, and limited partnership investment portfolios to support our underwriting business. The Indemnity and Exchange portfolios are managed with the objective of maximizing after-tax returns on a risk-adjusted basis, while the EFL portfolio is managed to be closely aligned to its liabilities and to maintain a sufficient yield to meet profitability targets. Management actively evaluates the portfolios for impairments. We record impairment writedowns on investments in instances where the fair value of the investment is substantially below cost, and we conclude that the decline in fair value is other-than-temporary, which includes consideration for intent to sell.
Unfavorable changes in economic conditions, including declining consumer confidence, inflation, high unemployment, and the threat of recession, among others, may lead the Property and Casualty Group’s customers to modify coverage, not renew policies, or even cancel policies, which could adversely affect the premium revenue of the Property and Casualty Group, and consequently Indemnity’s management fee. These conditions could also impair the ability of customers to pay premiums when due, and as a result, the Property and Casualty Group’s bad debt write-offs could increase. Our key challenge is to generate profitable revenue growth in a highly competitive market that continues to experience the effects of uncertain economic conditions.
Our portfolio of fixed income, preferred and common stocks, and limited partnerships are subject to market volatility especially in periods of instability in the worldwide financial markets. Over time, net investment income could also be impacted by volatility and by the general level of interest rates, which impact reinvested cash flow from the portfolio and business operations. Depending upon market conditions, which are unpredictable and remain uncertain, considerable fluctuation could exist in our reported total investment income, which could have an adverse impact on our financial condition, results of operations, and cash flows.
Expected loss ratio - An expected loss ratio is developed through a review of historical loss ratios by accident quarter, adjusted for changes to earned premium, mix of business and other factors that are expected to impact the loss ratio for the accident quarter being evaluated. A preliminary estimate of ultimate losses is calculated by multiplying this expected loss ratio by earned premium.
Weather event paid and reported development - The historical patterns utilized in paid and reported development methods for weather events are derived from historical data for the same type of weather event. Initial weather event ultimate loss estimates are reviewed with claims management.
Personal auto liability (such as bodily injury and uninsured/underinsured motorist) - For auto liability, and bodily injury in particular, we review the results of a greater number of techniques than for physical damage. We tend to rely on the Bornhuetter-Ferguson method for more recent experience periods and paid and incurred development methods for the older accident periods.
Impact of inflation - Property and casualty insurance reserves are established before the extent to which inflation may impact such reserves is known. Consequently, in establishing reserves, we attempt to anticipate the potential impact of inflation, including medical cost inflation, construction and auto repair cost inflation and tort issues. Medical costs are a broad element of inflation that impacts personal and commercial auto, general liability, workers compensation and commercial multi-peril lines of insurance written by the Property and Casualty Group. Inflation assumptions take the form of explicit numerical values in the survival ratio, individual claim, and massive injury lifetime medical reserving methods. Inflation assumptions are implicitly derived through the selection of applicable loss development patterns for all other reserving methods.
Workers compensation reserves, excluding massive injury lifetime medical claims, are also subject to discounting. The discount on these reserves was $62 million at December 31, 2013. A 100-basis point increase in the discount rate would decrease these reserves by $18 million.
We also perform analyses to evaluate the adequacy of past total reserve levels for the Property and Casualty Group. Using subsequent information, we perform retrospective reserve analyses to test whether previously established estimates for reserves were reasonable. Our 2013 retrospective reserve analysis for the loss reserve balance at December 31, 2012 indicated that direct reserves, including salvage and subrogation recoveries, were under-estimated by approximately $2 million, or 0.1% of the reserve estimate at December 31, 2012. In 2012, our retrospective reserve analysis indicated that direct reserves, including salvage and subrogation recoveries, were over-estimated by approximately $92 million, or 2.6% of the reserve estimate at December 31, 2011; and in 2011, our retrospective reserve analysis indicated that direct reserves, including salvage and subrogation recoveries, were over-estimated by approximately $276 million, or 7.7% of the reserve estimate at December 31, 2010. See an additional discussion of our reserve development in the “Prior year loss reserve development” section.
Reserves for traditional life insurance future policy benefits are computed primarily by the net level premium method. Generally, benefits are payable over an extended period of time and related reserves are calculated as the present value of future expected benefits to be paid reduced by the present value of future expected net premiums. Such reserves are established based upon methods and underlying assumptions in accordance with GAAP and applicable actuarial standards. Principal assumptions used in the establishment of policy reserves are mortality, lapses, expenses, and investment yields. Mortality assumptions are based upon tables typically used in the industry, modified to reflect actual experience and to include a provision for the risk of adverse deviation where appropriate. Lapse, expense, and investment yield assumptions are based upon actual company experience and may include a provision for the risk of adverse deviation. Assumptions on these policies are locked in at the time of issue and are not subject to change unless a premium deficiency exists. A premium deficiency exists if, based upon revised assumptions, the existing contract liabilities together with the present value of future gross premiums are not sufficient to cover the present value of future expected benefits and maintenance costs and to recover unamortized acquisition costs. Historically, our reserves plus expected gross premiums have been demonstrated to be sufficient. There were no premium deficiencies in 2013, 2012 or 2011.
Reserves for income-paying annuity future policy benefits are computed as the present value of future expected benefits. Principal assumptions used in the establishment of policy reserves are mortality and investment yields. Interest rates used to discount future expected benefits are set at the policy level and range from 1.50% to 9.0%. The equivalent aggregate interest rate is 5.7%. If the aggregate interest rate was reduced by 100 basis points, the present value of future expected benefits would increase by $17 million at December 31, 2013.
Level 1 primarily consists of publicly traded common stock, nonredeemable preferred stock, and exchange traded funds and reflects market data obtained from independent sources, such as prices obtained from an exchange or a nationally recognized pricing service for identical instruments in active markets.
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 municipal securities, asset backed securities, collateralized-mortgage obligations, foreign and domestic corporate bonds, and redeemable preferred stock and certain nonredeemable preferred stock.
Level 3 securities are valued based upon unobservable inputs, reflecting our estimates of value based upon assumptions used by market participants. Securities are assigned to Level 3 in cases where non-binding broker quotes are significant to the valuation and there is a lack of transparency as to whether these quotes are based upon information that is observable in the marketplace. Fair value estimates for securities valued using unobservable inputs require significant judgment due to the 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 are generally determined using comparable securities or non-binding broker quotes received from outside broker dealers based upon security type and market conditions. Remaining securities, where a price is not available, are 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 certain private securities as well as collateralized debt obligations.
When a price from the pricing service is not available, values are determined by obtaining non-binding broker quotes and/or market comparables. When available, we obtain multiple quotes for the same security. The ultimate value for these securities is determined based upon our best estimate of fair value using corroborating market information. Our evaluation includes the consideration of benchmark yields, reported trades, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data.
our ability and intent to retain the investment for a period of time sufficient to allow for a recovery in value (equity securities).
For available-for-sale equity securities, a charge is recorded in the Consolidated Statements of Operations for positions that have experienced other-than-temporary impairments. For debt securities in which we do not expect full recovery of amortized cost, the security is deemed to be credit-impaired. Credit-related impairments and impairments on securities we intend to sell or more likely than not will be required to sell are recorded in the Consolidated Statements of Operations. It is our intention to sell all debt securities with credit impairments.
We perform various procedures in review of the general partners’ valuations. While we rely on the general partners’ financial statements as the best available information to record our share of the partnership unrealized gains and losses resulting from valuation changes, we adjust our financial statements for impairments of the partnership investments where appropriate. As there is a limited market for these investments, they have the greatest potential for variability. We survey each of the general partners quarterly about expected significant changes (plus or minus 10% compared to previous quarter) to valuations prior to the release of the fund’s quarterly and annual financial statements. Based upon that information from the general partner, we consider whether additional disclosure is warranted. For limited partnerships measured at fair value based upon NAV, these values are then analyzed to determine if they represent NAV at the balance sheet date, with an adjustment being made where appropriate (change of plus or minus 5% compared to most recent NAV.)
DAC on life insurance and investment-type contracts are amortized in proportion to gross premiums, gross margins, or gross profits, depending on the type of contract. DAC related to traditional life insurance products is amortized in proportion to premium revenues over the premium-paying period of related policies using assumptions consistent with those used in computing policy liability reserves. These assumptions are not revised after policy issuance unless the DAC balance is deemed to be unrecoverable from future expected profits. In any period where the actual policy terminations are higher (lower) than anticipated policy terminations, DAC amortization will be accelerated (decelerated) in that period.
DAC related to universal life products and deferred annuities is amortized over the estimated lives of the contracts in proportion to actual and expected future gross profits, which include investment, mortality, and expense margins and surrender
The actuarial assumptions used to determine investment, mortality, and expense margins and surrender charges are reviewed periodically, are based upon best estimates and do not include any provision for the risk of adverse deviation. If actuarial analysis indicates that expectations have changed, the actuarial assumptions are updated and the investment, mortality, and expense margins and surrender charges are unlocked. If this unlocking results in a decrease in the present value of future expected gross profits, DAC amortization for the period will increase. If this unlocking results in an increase in the present value of future expected gross profits, DAC amortization for the current period will decrease.
DAC is periodically reviewed for recoverability. For traditional life products, if the benefit reserves plus anticipated future premiums and interest earnings for a line of business are less than the current estimate of future benefits and expenses (including any unamortized DAC), a charge to income is recorded for additional DAC amortization or for increased benefit reserves. For universal life products and deferred annuities, if the current present value of future expected gross profits is less than the unamortized DAC, a charge to income is recorded for additional DAC amortization. There were no impairments to DAC in 2013, 2012 or 2011.
Our pension plan for employees is the largest and only funded benefit plan we offer. Although Indemnity is the sponsor of these postretirement plans and records the funded status of these plans, the Exchange and EFL reimburse Indemnity for approximately 56% of the annual benefit expense of these plans, which represents pension benefits for Indemnity employees performing claims and EFL functions.
the yield curve and used to discount benefit payment amounts associated with each future year. The present value of plan benefits is calculated by applying the spot/discount rates to projected benefit cash flows. A single discount rate is then developed to produce the same present value. This represents the suggested discount rate. The cash flows from the yield curve were matched against our projected benefit payments in the pension plan, which have a duration of about 18 years. This yield curve supported the selection of a 5.11% discount rate for the projected benefit obligation at December 31, 2013 and for the 2014 pension expense. The same methodology was used to develop the 4.19% and 4.99% discount rates used to determine the projected benefit obligation for 2012 and 2011, respectively, and the pension expense for 2013 and 2012, respectively. A 25 basis point decrease in the discount rate assumption, with other assumptions held constant, would increase pension cost in the following year by $3 million and would increase the pension benefit obligation by $24 million.
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 gains and losses are recorded in the pension plan obligation and accumulated other comprehensive income (loss) on the Consolidated Statements of Financial Position. These amounts are systematically recognized to net periodic pension expense in future periods, with gains decreasing and losses increasing future pension expense. If actuarial net gains or losses exceed 5% of the greater of the projected benefit obligation and the market-related value of plan assets, the excess is recognized through the net periodic pension expense equally over the estimated service period of the employee group, which is currently 14-years. The level of actuarial net loss qualified for the corridor amortization in 2013, 2012 and 2011.
We use a four year averaging method to determine the market-related value of plan assets, which is used to determine the expected return component of pension expense. Under this methodology, asset gains or losses that result from returns that differ from our long-term rate of return assumption are recognized in the market-related value of assets on a level basis over a four year period. The market-related asset experience during 2013 that related to the actual investment return being different from that assumed during the prior year was a gain of $13 million. Recognition of this gain will be deferred and recognized over a four year period, consistent with the market-related asset value methodology. Once factored into the market-related asset value, these experience gains and losses will be amortized over a period of 14 years, which is the remaining service period of the employee group.
Estimates of fair values of the pension plan assets are obtained primarily from our trustee and custodian of our pension plan. Our Level 1 category includes a money market fund that is a mutual fund for which the fair value is determined using an exchange traded price provided by the trustee and custodian. Our Level 2 category includes commingled pools. Estimates of fair values for securities held by our commingled pools are obtained primarily from the trustee and custodian. The methodologies used by the trustee and custodian that support a financial instrument Level 2 classification include multiple verifiable, observable inputs including benchmark yields, reported trades, broker/dealer quotes, issuers spreads, two-sided markets, benchmark securities, bids, offers, and reference data. There were no Level 3 investments in 2013 or 2012. See Item 8. “Financial Statements and Supplementary Data - Note 15, Postretirement Benefits, of Notes to Consolidated Financial Statements” contained within this report for additional detail on the fair value measurements for the pension plan assets.
Direct written premium of the Property and Casualty Group increased 9.6% in 2013, compared to 2012, due to a 4.8% increase in policies in force and a 4.5% increase in the year-over-year average premium per policy for all lines of business. The year-over-year policy retention ratio was 90.6% at December 31, 2013, 90.9% at December 31, 2012, and 90.7% at December 31, 2011. See the “Property and Casualty Insurance Operations” segment that follows for a complete discussion of property and casualty direct written premium, which has a direct bearing on Indemnity’s management fee. The management fee rate was set at 25%, the maximum rate, for 2013, 2012 and 2011. The management fee rate for 2014 was set at 25% by our Board of Directors. Changes in the management fee rate can affect the Indemnity shareholder interest's revenue and net income from this segment significantly. See also, the “Transactions/Agreements between Indemnity and Noncontrolling Interest (Exchange), Board Oversight” section within this report.
Service agreement revenue includes service charges Indemnity collects from policyholders for providing extended payment terms on policies written by the Property and Casualty Group and late payment and policy reinstatement fees. Service charges are fixed dollar amounts per billed installment. Service agreement revenue totaled $31 million in both 2013 and 2012, and $33 million in 2011. The consistency in service agreement revenue in 2013 and 2012 compared to the growth in policies in force
Commissions - Commissions increased $75 million in 2013 compared to 2012, and increased $49 million in 2012 compared to 2011, primarily as a result of the 9.6% and 8.4%, respectively, increase in direct written premiums of the Property and Casualty Group. Commission expenses in 2013 and 2012 were also impacted by increased agent bonuses due to improvements in the profitability component of the bonus as a result of factoring in the most recent year’s underwriting data and policy growth. Impacting the increase in 2012 was an adjustment that reduced commission expense by $6 million. This amount represents the reimbursement by the North Carolina Reinsurance Facility (NCRF) for commissions Indemnity paid to agents on the surcharges collected on behalf of the NCRF which was incorrectly recorded as a benefit to the Exchange in prior periods.
Non-commission expense - Non-commission expense increased $30 million in 2013 compared to 2012. Underwriting and policy processing costs increased $9 million due to the 13.6% increase in new policies written. Administrative and other expenses increased $9 million driven by increases in professional fees and personnel costs of $5 million and $4 million, respectively. Information technology costs increased $5 million, which included $6 million of personnel costs, offset by a decrease of $1 million in software, hardware, and maintenance costs. Sales and advertising costs increased $4 million driven by increased personnel costs. Customer service costs increased $3 million due to an increase of $2 million in credit card processing fees and $1 million in personnel costs. Personnel costs in all expense categories were impacted by higher staffing levels, increased pension and medical costs, and increased estimates for incentive plan compensation costs related to growth and underwriting performance.
The gross margin in 2013 was 16.1%, compared to 17.3% in 2012 and 18.9% in 2011. Excluding the adjustment in 2012 that reduced commission expense by $6 million (described above), the gross margin would have been 16.8% in 2012.
Direct written premium - Direct written premium of the Property and Casualty Group increased 9.6% to $5.1 billion in 2013, from $4.6 billion in 2012, driven by an increase in policies in force and increases in average premium per policy. Year-over-year policies in force for all lines of business increased by 4.8% in 2013 as the result of continuing strong policyholder retention and an increase in new policies written, compared to 3.9% in 2012. The year-over-year average premium per policy for all lines of business increased 4.5% at December 31, 2013, compared to 4.3% at December 31, 2012. The combined impact of these increases was seen primarily in our renewal business and personal lines new business.
Premiums generated from new business increased 15.6% to $656 million in 2013, compared to 22.2%, or $568 million, in 2012. Underlying the trend in new business premiums was a 13.6% increase in new business policies written in 2013, compared to 13.4% in 2012, while the year-over-year average premium per policy on new business increased 1.8% at December 31, 2013, compared to 7.8% at December 31, 2012.
trends. The renewal business year-over-year average premium per policy increased 5.0% at December 31, 2013, compared to 3.9% at December 31, 2012. The Property and Casualty Group’s year-over-year policy retention ratio was 90.6% at December 31, 2013, 90.9% at December 31, 2012, and 90.7% at December 31, 2011.
The Property and Casualty Group implemented rate increases in 2013, 2012, and 2011 in order to meet loss cost expectations.
The Property and Casualty Group writes policies with annual terms only. Consequently, rate actions take 12 months to be fully recognized in written premium and 24 months to be fully 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 actions approved in 2012 were reflected in 2013, and recent rate actions in 2013 will be reflected in 2014. The Property and Casualty Group continuously evaluates pricing and product offerings to meet consumer demands.
Personal lines - Total personal lines premiums written increased 8.7% to $3.6 billion in 2013, from $3.3 billion in 2012, driven by an increase of 4.8% in total personal lines policies in force and an increase of 3.8% in the total personal lines year-over-year average premium per policy.
Private passenger auto new business premiums written increased 22.8% in 2013, compared to 15.7% in 2012. New business policies written for private passenger auto increased 19.5% in 2013, compared to 11.0% in 2012, while the new business year-over-year average premium per policy for private passenger auto increased 2.8% at December 31, 2013, compared to 4.2% at December 31, 2012.
Renewal premiums for commercial lines increased 12.9% in 2013, compared to 8.6% in 2012, driven by increases in average premium per policy and steady policy retention trends. The combined impact of these increases was seen primarily in the
federal assistance for personal lines terrorism losses. Although current models suggest the most likely occurrences would not have a material impact on the Property and Casualty Group, there is a chance that if future terrorism attacks occur, the Property and Casualty Group could incur large losses.
The 2011 direct business favorable development, including reserves for catastrophe losses and salvage and subrogation recoveries, totaled $276 million, improved the combined ratio by 6.7 points, and represented 7.7% of the net loss reserves at December 31, 2010. The most significant factors contributing to the 2011 favorable development were:
Ceded reinsurance - The Property and Casualty Group's ceded reinsurance reserve recoveries increased $8 million during 2013, compared to an increase of $9 million in 2012 and a decrease of $26 million in 2011. An increase in ceded recoveries is reflected as favorable loss development as it represents an increase in recoveries resulting from adverse development on our direct loss reserves, while a decrease in ceded recoveries is reflected as adverse loss development as it represents a decrease in recoveries resulting from favorable development on our direct loss reserves. Ceded reinsurance reserves primarily relate to the pre-1986 automobile massive injury claims. The increase in ceded recoveries in 2013 was primarily due to adverse development related to the pre-1986 automobile massive injury claims and the commercial multi-peril and business catastrophe liability lines of business, offset somewhat by favorable development in the workers compensation line of business. In 2012, the increase in ceded recoveries was primarily the result of adverse development related to the pre-1986 automobile massive injury claims. In 2011, the decrease in ceded recoveries was primarily the result of the closing of four massive injury lifetime medical claims.
EFL is a Pennsylvania-domiciled life insurance company which underwrites and sells individual and group life insurance policies and fixed annuities and operates in 10 states and the District of Columbia. EFL plans to expand operations into the Commonwealth of Kentucky by the first quarter of 2015 or earlier if possible. A summary of the results of our life insurance operations is as follows:
In 2013, total benefits and expenses were primarily impacted by increases in benefits and other changes in policy reserves, as a result of increases in death benefits and future policy benefits, and the amortization of deferred policy acquisition costs, as a result of the annual unlocking, compared to 2012. In 2012, other operating expenses increased, compared to 2011, due to a decrease in the amount of EFL's policy acquisition expenses deferred under the new accounting guidance effective in 2012 and lower ceding commissions.
Indemnity's equity in earnings of limited partnerships increased by $7 million in 2013, compared to 2012, and decreased by $11 million in 2012, compared to 2011, while earnings for the Exchange increased by $23 million and decreased by $7 million during the same respective periods. These changes in earnings for both Indemnity and the Exchange were primarily due to the performance of real estate investments.
(1) The Exchange’s results include equity in earnings of limited partnerships from EFL’s operations of $1 million in 2013, $0.1 million in 2012, and $4 million in 2011.
Limited partnership earnings tend to be cyclical based upon market conditions, the age of the partnership, and the nature of the investments. Generally, limited partnership earnings are recorded on a quarter lag from financial statements we receive from our general partners. As a consequence, earnings from limited partnerships reported at December 31, 2013 reflect investment valuation changes resulting from the financial markets and the economy for the twelve month period ending September 30, 2013.
We generate revenues from our fixed maturity, equity security and limited partnership investment portfolios to support our underwriting business. The Indemnity and Exchange portfolios are managed with the objective of maximizing after-tax returns on a risk-adjusted basis, while the EFL portfolio is managed to be closely aligned to its liabilities and to maintain a sufficient yield to meet profitability targets. Management actively evaluates the portfolios for impairments. We record impairment writedowns on investments in instances where the fair value of the investment is substantially below cost, and we conclude that the decline in fair value is other-than-temporary, which includes consideration for intent to sell.
We continually review our investment portfolio to evaluate positions that might incur other-than-temporary declines in value. For all investment holdings, general economic conditions and/or conditions specifically affecting the underlying issuer or its industry, including downgrades by the major rating agencies, are considered in evaluating impairment in value. In addition to specific factors, other factors considered in our review of investment valuation are the length of time the fair value is below cost and the amount the fair value is below cost.
We individually analyze all positions with emphasis on those that have, in management’s opinion, declined significantly below cost. In compliance with impairment guidance for debt securities, we perform further analysis to determine if a credit-related impairment has occurred. Some of the factors considered in determining whether a debt security is credit impaired include potential for the default of interest and/or principal, level of subordination, collateral of the issue, compliance with financial covenants, credit ratings and industry conditions. We have the intent to sell all credit-impaired debt securities, therefore the entire amount of the impairment charges are included in earnings and no impairments are recorded in other comprehensive income. For available-for-sale equity securities, a charge is recorded in the Consolidated Statements of Operations for positions that have experienced other-than-temporary impairments. (See the “Investment Operations” section herein for further information.) Management believes its investment valuation philosophy and accounting practices result in appropriate and timely measurement of value and recognition of impairment.
Under our investment strategy, we maintain a fixed maturity portfolio that is of high quality and well diversified within each market sector. This investment strategy also achieves a balanced maturity schedule. Our fixed maturity portfolio is managed with the goal of achieving reasonable returns while limiting exposure to risk. Our municipal bond portfolio accounts for $243 million, or 46%, of the total fixed maturity portfolio for Indemnity and $1.5 billion, or 18%, of the fixed maturity portfolio for the Exchange at December 31, 2013. The overall credit rating of the municipal portfolio without consideration of the underlying insurance is AA.
Fixed maturities classified as available-for-sale are carried at fair value with unrealized gains and losses, net of deferred taxes, included in shareholders’ equity. Indemnity’s net unrealized gains on fixed maturities, net of deferred taxes, amounted to $5 million at December 31, 2013, compared to $10 million at December 31, 2012. At December 31, 2013, the Exchange had net unrealized gains on fixed maturities of $234 million, compared to $449 million at December 31, 2012.
The following table presents a breakdown of the fair value of our fixed maturity portfolio by sector and rating for Indemnity and the Exchange, respectively:
Equity securities classified as available-for-sale include preferred and certain common stock securities, and are carried at fair value on the Consolidated Statements of Financial Position with all changes in unrealized gains and losses reflected in other comprehensive income. The unrealized loss on equity securities classified as available-for-sale, net of deferred taxes, for Indemnity was less than $0.1 million at December 31, 2013, compared to an unrealized gain of $1 million at December 31, 2012. The net unrealized gain on equity securities classified as available-for-sale, net of deferred taxes, for the Exchange was $26 million at December 31, 2013, compared to an unrealized gain of $48 million at December 31, 2012.
(1) Loss reserves are set at full expected cost, except for workers compensation loss reserves which have been discounted using an interest rate of 2.5%. This discounting reduced unpaid losses and loss expenses by $85 million at both December 31, 2013 and 2012.
reserves both decreased at December 31, 2013, compared to December 31, 2012, primarily due to the settlement of two pre-1986 automobile massive injury claims and the settlement of one workers compensation massive injury claim, offset somewhat by the addition of one new workers compensation massive injury claim, respectively.
EFL’s primary commitment is its obligation to pay future policy benefits under the terms of its life insurance and annuity contracts. To meet these future obligations, EFL establishes life insurance reserves based upon the type of policy, the age, gender, and risk class of the insured, and the number of years the policy has been in force. EFL also establishes annuity and universal life reserves based upon the amount of policyholder deposits (less applicable insurance and expense charges) plus interest earned on those deposits. Life insurance and annuity reserves are supported primarily by EFL’s long-term, fixed income investments as the underlying policy reserves are generally also of a long-term nature.
The funded status of our postretirement benefit plans is recognized in the statement of financial position, with a corresponding adjustment to accumulated other comprehensive income, net of tax. At December 31, 2013, shareholders’ equity increased by $81 million, net of tax, of which $10 million represents amortization of the prior service cost and net actuarial loss and $71 million represents the current period actuarial gain. The 2013 actuarial gain was primarily due to the change in the discount rate assumption used to measure the future benefit obligations to 5.11% in 2013, from 4.19% in 2012. At December 31, 2012, shareholders’ equity decreased by $30 million, net of tax, of which $8 million represents amortization of the prior service cost and net actuarial loss and $38 million represents the current period actuarial loss. The 2012 actuarial loss was primarily due to the change in the discount rate assumption used to measure the future benefit obligations to 4.19% in 2012, from 4.99% in 2011. Although Indemnity is the sponsor of these postretirement plans and records the funded status of these plans, the Exchange and EFL reimburse Indemnity for approximately 56% of the annual benefit expense of these plans, which represents pension benefits for Indemnity employees performing claims and EFL functions.
Net cash provided by operating activities totaled $903 million in 2013, $577 million in 2012, and $360 million in 2011. Increased cash from operating activities in 2013 was primarily due to an increase in premiums collected by the Exchange driven by the increase in premiums written, a decrease in losses and loss expense paid, and a slight increase in limited partnership distributions received. Somewhat offsetting this increase in cash was an increase in income taxes and other underwriting and acquisition costs paid, and a slight decrease in net investment income received, compared to 2012. The increase in 2012, compared to 2011, was primarily due to an increase in premiums collected by the Exchange driven by the increase in premiums written, a decrease in losses and loss expenses paid, and a slight increase in net investment income received. Offsetting this increase somewhat was an increase in income taxes and other underwriting and acquisition costs paid compared to 2011.
See Item 8. “Financial Statements and Supplementary Data - Note 22, Indemnity Supplemental Information, of Notes to Consolidated Financial Statements” contained within this report for more detail on Indemnity’s cash flows.
Net cash used by Indemnity’s investing activities totaled $65 million in 2013, compared to cash provided of $95 million in 2012, and cash used of $211 million in 2011. Indemnity’s 2013 investing activities primarily included decreased cash generated from the sales of fixed maturities and common stocks compared to 2012. Also impacting Indemnity's future investing activities are limited partnership commitments, which totaled $29 million at December 31, 2013, and will be funded as required by the partnerships’ agreements. Of this amount, the total remaining commitment to fund limited partnerships that invest in private equity securities was $14 million, mezzanine debt securities was $9 million, and real estate activities was $6 million. Indemnity’s investing activities in 2012 included increased cash generated from the sale of fixed maturities and common stocks combined with a decrease in other fixed maturity purchases, compared to 2011.
Net cash used in Indemnity’s financing activities totaled $116 million in 2013, $299 million in 2012, and $257 million in 2011. Decreased cash used in financing activities in 2013 was driven by a decrease in dividends paid to shareholders, due to the accelerated payment of the regular first quarter 2013 dividend into the fourth quarter of 2012 and a special one-time cash dividend, and a decrease in the cash outlay for share repurchases. Dividends paid to shareholders totaled $84 million, $229 million, and $102 million in 2013, 2012 and 2011, respectively. Indemnity increased both its Class A and Class B shareholder regular quarterly dividends for 2013 and 2012. In 2012, in addition to the regular quarterly dividend declared in November, the Board also declared a special one-time cash dividend of $2.00 on each Class A share and $300.00 on each Class B share, totaling $95 million. The payment of both the regular and special dividend was accelerated and paid in December 2012 due to the potential significant increases in tax rates on 2013 dividend income pending at the time of declaration. In 2013 and in 2011, the regular quarterly dividend was declared by the Board at its December meeting and paid in January of the following year. There are no regulatory restrictions on the payment of dividends to Indemnity’s shareholders. Dividends have been approved at a 7.2% increase for 2014.
We regularly prepare forecasts evaluating the current and future cash requirements of Indemnity and the Exchange for both normal and extreme risk events. Should an extreme risk event result in a cash requirement exceeding normal cash flows, we have the ability to meet our future funding requirements through various alternatives available to us.
Limited partnership commitments will be funded as required for capital contributions at any time prior to the agreement expiration date. The commitment amounts are presented using the expiration date as the factor by which to age when the amounts are due. At December 31, 2013, Indemnity’s total commitment to fund limited partnerships that invest in private equity securities was $14 million, mezzanine debt was $9 million, and real estate activities was $6 million. At December 31, 2013, the Exchange’s total commitment to fund limited partnerships that invest in private equity securities is $152 million, mezzanine debt of $160 million, and real estate activities $97 million.
Pension contribution for 2014 was estimated in accordance with the Pension Protection Act of 2006. Contributions anticipated in future years depend upon certain factors that cannot be reasonably predicted. If contributions become required in future years, they will be in an amount at least equal to the IRS minimum required contribution in accordance with this Act. The obligations for our unfunded benefit plans, including the Supplemental Employee Retirement Plan (SERP) for our executive and senior management, are not included in gross contractual obligations. The recorded accumulated benefit obligation for this plan at December 31, 2013, is $7 million. We expect to have sufficient cash flows from operations to meet the future benefit payments as they become due.
Reinsurance recoverables - life include estimated amounts from reinsurers on long-term liabilities subject to the credit worthiness of the reinsurer.
The outlook for all ratings is stable. According to AM Best, a “Superior” rating (A+), the second highest of their financial strength rating categories, is assigned to those companies that, in AM Best’s opinion, have achieved superior overall performance when compared to the standards established by AM Best and have a superior ability to meet their obligations to policyholders over the long term. Only 10.2% of insurance groups are rated A+ or higher, and we are included in that group. By virtue of its affiliation with the Property and Casualty Group, EFL is typically rated one level lower, or an “Excellent” rating (A), than our property and casualty insurance companies by AM Best Company. The insurers of the Property and Casualty Group are also rated by Standard & Poor’s, but this rating is based solely on public information. Standard & Poor’s rates these insurers Api, “strong.” Financial strength ratings continue to be an important factor in evaluating the competitive position of insurance companies.
The standard set by the National Association of Insurance Commissioners (NAIC) for measuring the solvency of insurance companies, referred to as Risk-Based Capital (RBC), is a method of measuring the minimum amount of capital appropriate for an insurance company to support its overall business operations in consideration of its size and risk profile. The RBC formula is used by state insurance regulators as an early warning tool to identify, for the purpose of initiating regulatory action, insurance companies that potentially are inadequately capitalized. In addition, the formula defines minimum capital standards that will supplement the current system of low fixed minimum capital and surplus requirements on a state-by-state basis. At December 31, 2013, the members of the Property and Casualty Group and EFL had RBC levels substantially in excess of levels that would require regulatory action.
We are exposed to many risks as a large property and casualty insurer with affiliated life insurance operations. The role of our Enterprise Risk Management ("ERM") function is to ensure that all significant risks are clearly identified, understood, proactively managed and consistently monitored to achieve strategic objectives for all stakeholders of the Erie Insurance Group. As an insurance company, we are in the business of taking risks from our policyholders, managing these risks in a cost-
Our risks can be broadly classified into insurance, investment, and operational risks. These risks are a consequence of our chosen business segments, the market and regulatory environment within which we operate, and unplanned operational events that can impact any business. Since certain risks can occur simultaneously or be correlated with other risks, an event or a series of events has the potential to impact multiple areas of our business and materially affect our operations, financial position or liquidity. Therefore our ERM program takes a holistic view of risk and ensures implementation of risk responses to mitigate potential impacts across our entire group of companies.
Our ERM process is founded on a governance framework that includes oversight at multiple levels of our organization, including our Board of Directors and executive management. Accountability to identify, manage, and mitigate risk is embedded within all functions and areas of our business. We have defined risk tolerances to monitor and manage significant risks within acceptable levels. In addition to identifying, evaluating, prioritizing, monitoring, and mitigating significant risks, our ERM process includes extreme event analyses and scenario testing. Financial and catastrophe modeling enable us to quantify risk within our property and casualty insurance operations and investment portfolio. Model output is used to quantify the potential variability of future performance and the sufficiency of capital levels given our defined tolerance for risk. These models provide insight into capital management, allocation of capital by product lines, catastrophe exposure management, and reinsurance purchasing decisions. Additionally, ERM tools have been developed and modified to enhance our ability to assess project level risk and to provide senior management with pertinent risk information, enabling them to make better informed decisions.
The Exchange leases certain office space to Indemnity, including the home office and three field office facilities. Rents are determined considering returns on invested capital and building operating and overhead costs. Rental costs of shared facilities are allocated based upon square footage occupied.
The allocation of costs affects the financial condition of the Erie Insurance Group companies. Management’s role is to determine that allocations are consistently made in accordance with the subscriber’s agreements with the policyholders at the Exchange, intercompany service agreements, and applicable insurance laws and regulations. Allocation of costs under these various agreements requires judgment and interpretation, and such allocations are performed using a consistent methodology, which is intended to adhere to the terms and intentions of the underlying agreements.
We have audited the accompanying consolidated statements of financial position of Erie Indemnity Company as of December 31, 2013 and 2012, and the related consolidated statements of operations, comprehensive income, shareholders' equity and noncontrolling interest, and cash flows for each of the three years in the period ended December 31, 2013. Our audits also included the financial statement schedules listed in the Index at 15 (a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Erie Indemnity Company at December 31, 2013 and 2012, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2013, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Erie Indemnity Company's internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission 1992 framework and our report dated February 27, 2014 expressed an unqualified opinion thereon.
Reclassification adjustment for gross losses (gains) included in net income, net of tax (benefit) expense of $(3), $23 and $27, respectively
Postretirement plans, net of tax expense (benefit) of $44, $(17) and $(22), respectively
Unrealized gains transferred to noncontrolling interest on sale of life affiliate, net of tax expense of $0, $0, and $4, respectively
Trading securities, at fair value (cost of $2,198 and $1,910, respectively)
Dividends declared - Class A ($2.4125, $4.25 and $2.0975 per share, respectively)
Indemnity plans to expand the property and casualty and life insurance operations of the Erie Insurance Group into the Commonwealth of Kentucky by the first quarter of 2015 or earlier if possible.
We consolidate the Exchange as a variable interest entity for which Indemnity is the primary beneficiary. All intercompany accounts and transactions have been eliminated in consolidation. The required presentation of noncontrolling interests is reflected in the consolidated financial statements. Noncontrolling interests represent the ownership interests of the Exchange, all of which is held by parties other than Indemnity (i.e., the Exchange’s subscribers (policyholders)). Noncontrolling interests also include the Exchange subscribers’ ownership interest in EFL.
In May 2011, the FASB issued ASU 2011-4, Fair Value Measurements. This guidance changed the description of the requirements in GAAP for measuring fair value and for disclosing information about fair value measurements and certain other changes to converge with the fair value guidance of the International Accounting Standards Board (“IASB”). The amendments in this guidance detail the requirements specific to measuring the fair value of an instrument classified in a reporting entity’s shareholders’ equity. The amendments also clarify that a reporting entity should disclose quantitative information about the significant unobservable inputs used in the fair value measurement categorized within Level 3 of the fair value hierarchy. ASU 2011-4 was effective for interim and annual periods beginning after December 15, 2011. The adoption of this new guidance did not have a material impact on our consolidated financial statements. The additional disclosures required by this guidance have been included in Note 6, “Fair Value”.
In February 2013, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. The amendments in this ASU require an entity to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the line items affected by the reclassification. For amounts that are not required to be reclassified in their entirety to net income, an entity is required to cross-reference to other related disclosures for additional information. ASU 2013-02 is effective prospectively for interim and annual periods beginning after December 15, 2012. We have elected to present amounts reclassified out of accumulated other comprehensive income by component and the respective line items of net income in the notes to our consolidated financial statements. See Note 18, "Indemnity Accumulated Other Comprehensive Loss".
In February 2013, the FASB issued ASU 2013-04, Obligations Resulting from Joint and Several Liability Arrangements for Which the Total Amount of the Obligation Is Fixed at the Reporting Date. The amendments in this ASU provide guidance for the recognition, measurement, and disclosure of obligations resulting from joint and several liability arrangements for which the total amount of the obligation within the scope of this guidance is fixed at the reporting date, except for obligations addressed within existing guidance in GAAP. ASU 2013-04 is effective for interim and annual periods beginning after December 15, 2013, with early adoption permitted. We do not expect the adoption of this new guidance to have a material impact on our consolidated financial statements.
Available-for-sale securities - Fixed maturity, preferred stock, and common stock securities classified as available-for-sale are reported at fair value. Unrealized holding gains and losses, net of related tax effects, on available-for-sale securities are charged or credited directly to shareholders’ equity as accumulated other comprehensive income (loss).
Limited partnerships - Limited partnerships include U.S. and foreign private equity, mezzanine debt, and real estate investments. The majority of our limited partnership holdings are considered investment companies and are recorded using the equity method of accounting. For these limited partnerships the general partners record assets at fair value, including any other-than-temporary impairments of these individual investments. We also own some real estate limited partnerships that do not meet the criteria of an investment company. These partnerships prepare their audited financial statements on a cost basis. We have elected to report these limited partnerships under the fair value option, which is based on the net asset value (NAV) from our partner’s capital statement reflecting the general partner’s estimate of fair value for the fund’s underlying assets. Limited partnerships reported under the fair value option are disclosed in Note 6, “Fair Value” as other investments. Fair value provides consistency in the evaluation and financial reporting for these limited partnerships and limited partnerships accounted for under the equity method.
Acquisition costs that vary with and relate to the successful production of insurance and investment-type contracts are deferred. Beginning in 2012, deferred acquisition costs (“DAC”) are incremental direct costs of contract acquisition and are limited to the successful acquisition of new and renewal contracts. Such costs consist principally of commissions, premium taxes and policy issuance expenses. Prior to 2012, certain of these acquisition costs were deferred regardless of whether a contract was acquired.
Life insurance - DAC related to traditional life insurance products is amortized in proportion to premium revenues over the premium-paying period of related policies using assumptions about mortality, morbidity, lapse rates, expenses, and future yield on related investments established when the policy was issued. Amortization is adjusted each period to reflect policy lapse or termination rates as compared to anticipated experience. DAC related to universal life products and deferred annuities is amortized over the estimated lives of the contracts in proportion to actual and expected future gross profits, investment, mortality, expense margins, and surrender charges. Both historical and anticipated investment returns, including realized gains and losses, are considered in determining the amortization of DAC.
Deferred tax assets and liabilities are recorded for temporary differences between the tax basis of assets and liabilities and their reported amounts in the consolidated financial statements, using the statutory tax rates in effect for the year in which the differences are expected to reverse. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the results of operations in the period that includes the enactment date under the law. Valuation allowances on deferred tax assets are estimated based upon our assessment of the realizability of such amounts.
Unpaid losses and loss expenses include estimates for claims that have been reported and those that have been incurred but not reported, as well as estimates of all expenses associated with processing and settling these claims, less estimates of anticipated salvage and subrogation recoveries. Unpaid loss and loss expense reserves are set at full expected cost, except for workers compensation loss reserves, which have been discounted using an interest rate of 2.5%. Estimating the ultimate cost of future losses and loss expenses is an uncertain and complex process. This estimation process is based upon the assumption that past developments are an appropriate indicator of future events, and involves a variety of actuarial techniques that analyze experience, trends, and other relevant factors. The uncertainties involved with the reserving process include internal factors, such as changes in claims handling procedures, as well as external factors, such as economic trends and changes in the concepts of legal liability and damage awards. Accordingly, final loss settlements may vary from the present estimates, particularly when those payments may not occur until well into the future.
The liability for future benefits of life insurance contracts is the present value of such benefits less the present value of future net premiums. Life insurance and income-paying annuity future policy benefit reserves are computed primarily by the net level
premium method with assumptions as to mortality, withdrawal, lapses, and investment yields. Traditional life insurance products are subject to loss recognition testing. The adequacy of the related reserves is verified as part of loss recognition testing. Loss recognition is necessary when the sum of the reserve and the present value of projected policy cash flows is less than unamortized DAC.
At December 31 of each year, we use actual data available and record an accrual based upon the expected payment amount. These costs are included in the policy acquisition and underwriting expenses in the Consolidated Statements of Operations.
Indemnity has not provided financial or other support to the Exchange for any of the reporting periods presented. At December 31, 2013, there are no explicit or implicit arrangements that would require Indemnity to provide future financial support to the Exchange. Indemnity is not liable if the Exchange was to be in violation of its debt covenants or was unable to meet its obligation for unfunded commitments to limited partnerships.
Additionally, the year ended December 31, 2012 includes an adjustment that reduced commission expense by $6 million. This amount represents the reimbursement by the North Carolina Reinsurance Facility (NCRF) for commissions Indemnity paid to agents on the surcharges collected on behalf of the NCRF which was incorrectly recorded as a benefit to the Exchange in prior periods. If these amounts had been correctly recorded, Indemnity’s commission expense would have been lower by $0.5 million for the year ended December 31, 2011.
Our property and casualty insurance operations segment includes personal and commercial lines. Personal lines consist primarily of personal auto and homeowners and are marketed to individuals. Commercial lines consist primarily of commercial multi-peril, commercial auto, and workers compensation and are marketed to small- and medium-sized businesses. Our property and casualty policies are sold by independent agents. Our property and casualty insurance underwriting operations are conducted through the Exchange and its subsidiaries and include assumed voluntary reinsurance from nonaffiliated domestic and foreign sources, assumed involuntary, and ceded reinsurance business. The Exchange exited the assumed voluntary reinsurance business effective December 31, 2003, and therefore unaffiliated assumed voluntary reinsurance includes only run-off activity of the previously assumed voluntary reinsurance business. We evaluate profitability of the property and casualty insurance operations principally based upon net underwriting results represented by the combined ratio.
The investment operations segment includes returns from our fixed maturity, equity security and limited partnership investment portfolios to support our underwriting business. The Indemnity and Exchange portfolios are managed with the objective of maximizing after-tax returns on a risk-adjusted basis, while the EFL portfolio is managed to be closely aligned to its liabilities and to maintain a sufficient yield to meet profitability targets. Management actively evaluates the portfolios for impairments. We record impairment writedowns on investments in instances where the fair value of the investment is substantially below cost, and we conclude that the decline in fair value is other-than-temporary. Investment-related income for the life operations is included in the investment segment results.
For both Indemnity and the Exchange, there were no transfers between Level 1 and Level 2, or Level 2 and Level 3, for the three months ended December 31, 2013.
(1) Other investments measured at fair value represent four real estate funds included on the balance sheet as limited partnership investments that are reported under the fair value option. These investments can never be redeemed with the funds. Instead, distributions are received when liquidation of the underlying assets of the funds occur. It is estimated that the underlying assets will generally be liquidated between 5 and 10 years from the inception of the funds. The fair value of these investments is based on the net asset value (NAV) information provided by the general partner. Fair value is based on our proportionate share of the NAV based on the most recent partners' capital statements received from the general partners, which is generally one quarter prior to our balance sheet date. These values are then analyzed to determine if they represent the NAV at our balance sheet date, with adjustment being made where appropriate. We consider observable market data and perform a review validating the appropriateness of the NAV at each balance sheet date. It is likely that all of the investments will be redeemed at a future date for an amount different than the NAV of our ownership interest in partners' capital as of December 31, 2012. During the year ended December 31, 2012, Indemnity made contributions totaling $0.2 million and received distributions totaling $0.3 million, and the Exchange made contributions totaling $0.7 million and received distributions totaling $4.7 million for these investments. As of December 31, 2012, the amount of unfunded commitments related to the investments was $1.5 million for Indemnity and $4.5 million for the Exchange.
For the Exchange, Level 1 to Level 2 transfers totaled $69 million, and there were no Level 2 to Level 1 transfers for the three months ended December 31, 2012. Trading activity levels for 10 preferred stock holdings necessitated reclassification between levels. In addition, seven U.S. Treasury securities were reclassified from Level 1 to Level 2. Level 2 to Level 3 transfers totaled $12 million related to one fixed maturity holding, and Level 3 to Level 2 transfers totaled $35 million related to one preferred stock and three fixed maturity holdings. These transfers in and out of Level 3 were primarily the result of using unobservable and observable market data, respectively, to determine the fair value at December 31, 2012.
For Indemnity, Level 1 to Level 2 transfers in Indemnity totaled $5 million for the year ended December 31, 2012. Trading activity levels for two preferred stock holdings necessitated reclassification between levels, and there were no Level 2 to Level 1 transfers. Level 2 to Level 3 transfers totaled $1 million due to trading activity levels related to one fixed maturity holding, and there were no transfers from Level 3 to Level 2.
For the Exchange, Level 1 to Level 2 transfers in the Exchange totaled $79 million for the year ended December 31, 2012. Trading activity levels for eight preferred stock holdings necessitated reclassification between levels. In addition, eight U.S. Treasury securities were reclassified from Level 1 to Level 2. Level 2 to Level 1 transfers totaled $12 million due to trading activity levels for one preferred stock holding. Level 2 to Level 3 transfers totaled $33 million related to five fixed maturity holdings, and Level 3 to Level 2 transfers totaled $11 million related to one preferred stock and two fixed maturity holdings. These transfers in and out of Level 3 were primarily the result of using unobservable and observable market data, respectively, to determine the fair value at December 31, 2012.
The following table presents our consolidated fair value measurements on a recurring basis by pricing source at December 31, 2013:
There were no assets measured at fair value on a nonrecurring basis during the year ended December 31, 2013.
The amortized cost and estimated fair value of fixed maturities at December 31, 2013, are shown below by remaining contractual term to maturity. Mortgage-backed securities are allocated based upon their stated maturity dates. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Available-for-sale securities in a gross unrealized loss position at December 31, 2012 are as follows. Data is provided by length of time for securities in a gross unrealized loss position.
The above securities for Indemnity and the Exchange have been evaluated and determined to be temporary impairments for which we expect to recover our entire principal plus interest. The primary components of this analysis include a general review of market conditions and financial performance of the issuer along with the extent and duration at which fair value is less than cost. Any securities that we intend to sell or will more likely than not be required to sell before recovery are included in other-than-temporary impairments with the impairment charges recognized in earnings.
Limited partnership investments, excluding certain real estate limited partnerships recorded at fair value, are generally reported on a one-quarter lag, therefore our year-to-date limited partnership results through December 31, 2013 are comprised of partnership financial results for the fourth quarter of 2012 and the first, second and third quarters of 2013. Given the lag in reporting, our limited partnership results do not reflect the market conditions of the fourth quarter of 2013. Cash contributions made to and distributions received from the partnerships are recorded in the period in which the transaction occurs.
Change in fair value of limited partnerships accounted for under the fair value option
As these investments are generally reported on a one-quarter lag, our limited partnership results through December 31, 2013 include partnership financial results for the fourth quarter of 2012 and the first three quarters of 2013.
Per the limited partnership financial statements, total partnership assets were $50 billion and total partnership liabilities were $5 billion at December 31, 2013 (as recorded in the September 30, 2013 limited partnership financial statements). For the twelve month period comparable to that presented in the preceding table (fourth quarter of 2012 and first three quarters of 2013), total partnership valuation adjustment gains were $2 billion and total partnership net income was $7 billion.
Per the limited partnership financial statements, total partnership assets were $53 billion and total partnership liabilities were $6 billion at December 31, 2012 (as recorded in the September 30, 2012 limited partnership financial statements). For the twelve month period comparable to that presented in the preceding table (fourth quarter of 2011 and first three quarters of 2012), total partnership valuation adjustment gains were $2 billion and total partnership net income was $5 billion.
See also Note 19, “Commitments and Contingencies,” for investment commitments related to limited partnerships.
We capitalize computer software costs developed or obtained for internal use. Capitalized costs include internal and external labor and overhead, all of which are attributable to Indemnity. Capitalization ceases and amortization begins no later than the point at which a computer software project is complete and ready for its intended use. Capitalized software costs are amortized over the estimated useful life of the software.
The deferred income tax expense in 2013 and 2012 was primarily driven by unrealized gains on investments. The deferred income tax benefit in 2011 was primarily driven by unrealized losses on common stock.
A reconciliation of the provision for income taxes, with amounts determined by applying the statutory federal income tax rates to pre-tax income, is as follows for the years ended December 31:
The following table summarizes the components of the Property and Casualty Group’s and EFL’s deferred policy acquisition costs assets for the years ended December 31:
The reinsurance credit related to life policy and deposit contract reserves was $134 million, $122 million and $108 million at December 31, 2013, 2012 and 2011 respectively, and is presented in other assets in the Consolidated Statements of Financial Position.
Members of the Property and Casualty Group participate in an intercompany reinsurance pooling agreement. Under the pooling agreement, all insurance business of the Property and Casualty Group is pooled in the Exchange. EIC and ENY share in the underwriting results of the reinsurance pool through retrocession. Since 1995, the Board of Directors has set the allocation of the pooled underwriting results at 5.0% participation for EIC, 0.5% participation for ENY, and 94.5% participation for the Exchange. 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 geographic regions in which each operates. This agreement may be terminated by any party as of the end of any calendar year by providing not less than 365 days advance written notice. Intercompany pooling accounts are settled in cash within 30 days after the end of each quarterly accounting period.
In addition to the property catastrophe treaties, the Property and Casualty Group also cedes certain individual lines of business to unaffiliated reinsurers and cedes certain individual risks on a facultative basis. The Property and Casualty Group maintains several 100% quota share agreements with A.M. Best A++ rated Hartford Steam Boiler Inspection and Insurance Company. These agreements cede 100% of the covered insurance risk relating to the reinsured portions of the equipment breakdown, employment practices liability, and identity recovery lines of business. During 2013, the Property and Casualty Group ceded a total of $21 million in premium to Hartford Steam Boiler. The cessions for 2012 and 2011 were $17 million and $14 million respectively.
EFL maintains several reinsurance treaties with nonaffiliated life reinsurance companies in order to reduce claims volatility. EFL had direct life insurance in force totaling $45 billion and $44 billion at December 31, 2013 and 2012, respectively. Of these amounts, EFL ceded $21 billion and $22 billion of life insurance in force at December 31, 2013 and 2012, respectively. The largest amount of in force life insurance ceded to one reinsurer totaled $10 billion and $11 billion at December 31, 2013 and 2012, respectively.
Although Indemnity is the sponsor of these postretirement plans and records the funded status of these plans, the Exchange and EFL reimburse Indemnity for approximately 56% of the annual benefit expense of these plans, which represents pension benefits for Indemnity employees performing claims and EFL functions. For our funded pension plan, amounts are settled in cash for the portion of pension costs allocated to the Exchange and EFL, respectively. For our unfunded plans, we pay the obligations when due and amounts are settled in cash between entities when there is a payout.
The rate of compensation increase for the employee plan is age-graded. An equivalent single compensation increase rate of 4.15% in 2013, 2012 and 2011 would produce similar results.
The two economic assumptions that have the most impact on the postretirement benefit expense are the discount rate and the long-term rate of return on plan assets. The discount rate assumption used to determine the benefit obligation for 2013 was based upon a yield curve developed from corporate bond yield information. The same methodology was employed to develop the discount rates used to determine the benefit obligation for 2012 and 2011, respectively.
Benefit obligations are described in the following tables. Accumulated and projected benefit obligations (“ABO” and “PBO”) represent the obligations of a pension plan for past service as of the measurement date. ABO is the present value of benefits earned to date with benefits computed based on current compensation levels. PBO is ABO increased to reflect expected future compensation. The following tables set forth the change in our projected benefit obligation, the accumulated benefit obligation, and information for the defined benefit pension plans with an accumulated benefit obligation in excess of plan assets as of December 31:
At December 31, 2013, the SERP had an accumulated benefit obligation in excess of plan assets. At December 31, 2012, both the defined benefit pension plan and the SERP had an accumulated benefit obligation in excess of plan assets.
Debt securities - 44% are allocated to long U.S. Treasury Strips, 44% are allocated to U.S. corporate bonds with an emphasis on long duration bonds rated A or better, while the remaining 12% are allocated to floating rate high income leverage loans.
The retiree health benefit plan was terminated in 2006. We continue to provide retiree health benefits only to employees who met certain age and service requirements on or before July 1, 2010. The accumulated benefit obligation and net periodic benefit cost of this plan were not material to our consolidated financial statements.
Our annual incentive plan is a bonus plan that pays cash to our executive and senior vice presidents annually. The cash awards are based on attainment of corporate and individual performance measures, which can include various financial measures. The plan includes a funding qualifier which considers Indemnity’s financial results, based on operating income, before a payout can be made to plan participants. If the funding qualifier is met, plan participants are eligible to receive the incentive based upon specific performance measures. The measures are established at the beginning of each year by the Executive Compensation and Development Committee of our Board of Directors (“ECDC”), with ultimate approval by the full Board of Directors. For 2013 and 2012, the performance measures primarily included the Property and Casualty Group’s direct written premium and statutory combined ratio.
Our long-term incentive plan (“LTIP”) is a performance based incentive plan designed to reward executive and senior vice presidents 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 LTIP permits grants of performance shares or units, to be satisfied with shares of our Class A common stock or cash payment as determined by the ECDC. The ECDC determines the form of the award to be granted at the beginning of each performance period, which is generally a three-year period. The number of shares of the Company’s common stock authorized for grant under the LTIP is 1 million shares, with no one person able to receive more than 250,000 shares or the equivalent of $3 million during any one performance period. We repurchase our Class A common stock on the open market to settle plan awards. We do not issue new shares of common stock to settle plan awards. LTIP awards are considered vested at the end of each applicable performance period.
At December 31, 2013, the plan awards for the 2011-2013 performance period were fully vested. Distributions will be made in the form of Class A common stock in 2014 once peer group financial information becomes available. The estimated plan award based upon the peer group information as of September 30, 2013 is $6 million. At December 31, 2012, the awards for the 2010-2012 period were fully vested and the related cash award of $5 million was paid in May 2013. At December 31, 2011, the awards for the 2009-2011 performance period were fully vested and the related cash award of $5 million was paid in June 2012.
Effective April 17, 2013, our Board of Directors approved an equity compensation plan (“ECP”) 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 Indemnity’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. Share awards are settled through the repurchase of our Class A common stock on the open market. We do not issue new shares of common stock to satisfy plan awards.
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. There were no awards granted during 2013.
Our deferred compensation plans are arrangements for our executive and senior vice presidents and outside directors that allows participants to elect to defer receipt of a portion of their compensation until a later date. Employer 401(k) matching contributions that are in excess of the annual contribution or compensation limits are also credited to the participant accounts for those who elected to defer receipt of some portion of their base salary. The deferred compensation plan for our outside directors allows participants to defer receipt of a portion of their director and meeting fees until a later date. Employees or outside directors participating in the respective plans select hypothetical investment funds for their deferrals which are credited with the hypothetical returns generated.
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 conversions of Class B shares to Class A shares in 2013. In 2012, four shares of Class B common stock were converted into 9,600 shares of Class A common stock. There were no conversions of Class B shares to Class A shares in 2011. There is no provision for conversion of Class A shares to Class B shares, and, Class B shares surrendered for conversion cannot be reissued.
A stock repurchase program was authorized for our outstanding Class A nonvoting common stock beginning January 1, 2004. Treasury shares are recorded in the Consolidated Statements of Financial Position at total cost based upon trade date. Shares repurchased under this program, based upon trade date, totaled 431,556 at a total cost of $31.2 million during 2013, and 978,761 shares at a total cost of $69.5 million during 2012. In October 2011, our Board of Directors approved a continuation of the current stock repurchase program for a total of $150 million, with no time limitation. We had approximately $37 million of repurchase authority remaining under this program at December 31, 2013, based upon trade date.
Changes in Indemnity's accumulated other comprehensive loss by component attributable to the Indemnity shareholder interest is presented as follows for the year ended December 31, 2013:
Amounts reclassified from accumulated other comprehensive (loss) income, net of tax(1)
Positive amounts indicate net income, while negative amounts indicate net loss.
Indemnity has contractual commitments to invest up to $29 million related to its limited partnership investments at December 31, 2013. These commitments are split between private equity securities of $14 million, mezzanine debt securities of $9 million, and real estate activities of $6 million. These commitments will be funded as required by the limited partnership agreements.
The Exchange, including EFL, has contractual commitments to invest up to $409 million related to its limited partnership investments at December 31, 2013. These commitments are split between private equity securities of $152 million, mezzanine debt securities of $160 million, and real estate activities of $97 million. These commitments will be funded as required by the limited partnership agreements.
The amount of dividends that can be paid to the Exchange without the prior approval by the Pennsylvania Insurance Commissioner by EFL, a Pennsylvania-domiciled life insurer, is limited by statute to the greater of: (a) 10% of statutory surplus as shown in the last annual statement on file with the commissioner, or (b) net income as reported in the last annual statement, but shall not include pro-rata distribution of any class of the insurer’s own securities. Accordingly, the maximum dividend payout that the Exchange could receive in 2014 without prior Pennsylvania Commissioner approval is $29 million. There were no dividends paid to either the Exchange or Indemnity in 2013, 2012 or 2011.
Management fees and expense allocation amounts due from the Exchange were $296 million and $278 million at December 31, 2013 and 2012, respectively. The receivable from EFL for expense allocations and interest on the surplus note totaled $4 million and $3 million at December 31, 2013 and 2012, respectively.
Office leases - Indemnity leases certain office space from the Exchange, including the home office and three field office facilities. Rent expenses under these leases totaled $6 million in 2013, 2012 and 2011. Indemnity also has a lease commitment with EFL for a branch office until 2018. Annual rentals paid to EFL under this lease totaled $0.4 million in 2013, 2012 and 2011.