The member companies of the Erie Insurance Group share a corporate home office complex in Erie, Pennsylvania, which is comprised of approximately 500,000 square feet. The home office complex is owned by the Exchange. We are charged rent for the related square footage we occupy.
The Erie Insurance Group also operates 23 field offices in 11 states. Seventeen of these offices provide both agency support and claims services and are referred to as branch offices, while the remaining six provide only claims services and are considered claims offices. While we own three of these field offices, we lease the remaining field offices from other parties as detailed below.
On April 1, 2009, we adopted the accounting guidance related to non-credit other-than-temporary impairments for our debt security portfolio. The net impact of the cumulative effect adjustment on April 1, 2009 increased retained earnings and reduced other comprehensive income by $6.7 million, net of tax, resulting in no effect on shareholder’s equity.
On January 1, 2008, we adopted the fair value option for our common stock portfolio. The net impact of the cumulative effect adjustment increased retained earnings and reduced other comprehensive income by $11.2 million, net of tax, resulting in no effect on shareholder’s equity.
Includes 1.9 million shares of our Class A non-voting common stock from the F. William Hirt Estate separate from our stock repurchase program.
Certain statements contained herein are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements are not in the present or past tense and can generally be identified by the use of words such as “anticipate,” “believe,” “estimate,” “expect,” “intend,” “likely,” “plan,” “project,” “seek,” “should,” “target,” “will,” and other expressions that indicate future trends and events. Forward-looking statements 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 such statements are discussions relating to management fee revenue, cost of management operations, underwriting, premium and investment income volumes, and agency appointments. Such statements are not guarantees of future performance and involve risks and uncertainties that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in such forward-looking statements. Among the risks and uncertainties that could cause actual results and future events to differ materially from those set forth or contemplated in the forward-looking statements are the following:
factors affecting the property/casualty and life insurance industries generally, including price competition, legislative and regulatory developments;
government regulation of the insurance industry including approval of rate increases;
the geographic concentration of our business as a result of being a regional company;
We are a Pennsylvania business corporation that since 1925 has been the managing attorney-in-fact for the subscribers of the Erie Insurance Exchange (“Exchange”), a reciprocal insurer that writes property/casualty insurance. Our primary function is to perform certain services relating to sales, underwriting and issuance of policies on behalf of the Exchange. We earn a management fee from the Exchange for these services.
We have three operating segments: management operations, insurance operations and investment operations.
Our earnings are driven primarily by the management fee revenue we collect from the Exchange that is based on the direct written premiums of the Property and Casualty Group and the management fee rate we charge. Because of this
The management fee is calculated as a percentage, not to exceed 25%, of the direct written premiums of the Property and Casualty Group. The Board of Directors establishes the rate at least annually and considers such factors as relative financial strength of the Exchange and Company and projected revenue streams. Our Board set the 2010 rate at 25%, its maximum level.
We generate revenues from our property/casualty insurance subsidiaries, which consist of our share of the pooled insurance business of the Property and Casualty Group. Members of the Property and Casualty Group participate in an intercompany reinsurance pooling agreement where all insurance business is pooled in the Exchange. Under the pooling agreement, the Exchange assumes 94.5% of the Property and Casualty Group’s underwriting results. Through the pool, our subsidiaries Erie Insurance Company and Erie Insurance Company of New York, currently assume 5.5% of the Property and Casualty Group’s underwriting results, providing a direct incentive for us to manage the insurance underwriting discipline as effectively as possible.
Both personal lines and commercial lines net written premiums are experiencing highly competitive market conditions with the recessionary economic conditions. A light catastrophe season for the industry, coupled with some recovery in the financial markets, indicate increasing industry surplus and underwriting capacity. Despite an increase in loss cost drivers as a result of an increasing frequency trend, the Property and Casualty Group has experienced lower losses, primarily due to a reduction in large claims. The Property and Casualty Group’s economically sensitive lines, such as workers compensation and commercial auto, experienced reduced exposures and reduced average premium per policy due to economic conditions.
We generate revenues from our fixed maturity, equity security and alternative investment portfolios. The portfolios are managed with a view toward maximizing after-tax yields and limiting credit risk, and 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.
Our investment operations, while still showing overall losses driven primarily from our alternative investments, reflected the improvement experienced in the financial markets in the latter half of 2009. During 2009, we impaired $12.1 million of securities compared to $69.5 million in 2008. The decrease in our 2009 impairments included the change in impairment policy as a result of the new impairment guidance for debt securities effective for the second quarter of 2009. As a result, only debt securities that have a credit related issue, or we intend to sell, or more than likely will be required to sell, are now included as impairments recognized in earnings.
Increase in net income per share-diluted in 2009 was impacted by improved performance in our investment operations overall as the financial markets showed signs of recovery in 2009 compared to 2008.
Gross margins from management operations increased to 18.7% in 2009 from 17.6% in 2008.
In 2009, the direct written premiums of the Property and Casualty Group increased 1.6% compared to 0.4% in 2008. Policies in force grew 3.5% in 2009, compared to 2.9% in 2008. The growth in policies in force for both years is the result of continuing strong policyholder retention rates and increased new policies sold. Reductions in the average premium per policy were 1.9% in 2009 compared to 2.5% in 2008. While modest rate increases were implemented in 2009, these were offset by exposure reductions and changes in our mix of business, which resulted in a slight decrease in our average premium per policy in 2009. Rate reductions implemented by the Property and Casualty Group were the primary driver of the reduction in the average premium per policy in 2008.
The cost of management operations increased 0.5%, or $3.9 million, to $813.4 million in 2009, primarily due to an increase in non-commission expenses:
Total costs other than commissions - All other non-commission expense increased 2.1%, to $261.1 million in 2009. Personnel costs increased primarily due to higher pension benefit costs and increased management incentive plan expense. Increased salaries and wages were offset by the capitalization of internal labor costs related to various technology initiatives. Survey and underwriting costs rose due to increased application activity. Other operating cost increases were driven by contract labor costs related to various technology initiatives.
Contributing to underwriting income of $1.6 million and a GAAP combined ratio of 99.2 in 2009, compared to income of $13.3 million and a GAAP combined ratio of 93.6 in 2008, were the following factors:
favorable development of prior accident year loss reserves of 2.4 points, or $5.1 million, in 2009 compared to 5.0 points, or $10.3 million, of favorable development in 2008;
our share of the Property and Casualty Group’s write-off of assumed involuntary reinsurance premium contributed 1.3 points to our 2009 GAAP combined ratio.
Equity in earnings of EFL was $5.6 million in 2009 compared to losses of $14.6 million in 2008 driven by lower impairment charges of $22.9 million in 2009 compared to $83.5 million in 2008.
The topics addressed in this overview are discussed in more detail in the sections that follow.
We use operating income to evaluate the results of operations. It reveals trends in our management services, insurance underwriting and investment operations that may be obscured by the net effects of realized capital gains and losses including impairment losses. Realized capital gains and losses including impairment losses, may vary significantly between periods and are generally driven by business decisions and economic developments such as capital market conditions, the timing of which is unrelated to our management services and insurance underwriting processes. We believe it is useful for investors to evaluate these components separately and in the aggregate when reviewing our performance. We are aware that the price to earnings multiple commonly used by investors as a forward-looking valuation technique uses operating income as the denominator. Operating income should not be considered as a substitute for net income and does not reflect our overall profitability.
The following table reconciles operating income and net income for the periods ended December 31:
The decrease in operating income was primarily the result of equity in losses of limited partnerships of $76.1 million in 2009 compared to earnings of $5.7 million in 2008.
An inactive (illiquid) market is one in which there are few and infrequent transactions, where the prices are not current, price quotations vary substantially, and/or there is little information publicly available for the asset being valued.
We continually assess whether or not an active market exists for all of our investments and as of each reporting date re-evaluate the classification in the fair value hierarchy.
All assets carried at fair value are classified and disclosed in one of the following three categories:
Level 2 - Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.
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 stocks and certain nonredeemable preferred stocks.
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 on security type and market conditions. Remaining un-priced securities are valued using an estimate of fair value based on indicative market prices that include significant unobservable inputs not based on, 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 preferred stock and bond securities, collateralized debt and loan obligations, and credit linked notes.
As of each reporting period, financial instruments recorded at fair value are classified based on the lowest level of input that is significant to the fair value measurement. The presence of at least one unobservable input would result in classification as a Level 3 instrument. Our assessment of the significance of a particular input to the fair value measurement requires judgment, and considers factors specific to the asset, such as the relative impact on the fair value as a result of including a particular input and market conditions. We did not make any other significant judgments except as described above.
Estimates of fair values for our investment portfolio are obtained primarily from a nationally recognized pricing service. Our Level 1 category includes those securities valued using an exchange traded price provided by the pricing service. The methodologies used by the pricing service that support a Level 2 classification of a financial instrument include multiple verifiable, observable inputs including benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers and reference data. Pricing service valuations for Level 3 securities are based on proprietary models and are used when observable inputs are not available in illiquid markets. In limited circumstances we adjust the price received from the pricing service when in our judgment a better reflection of fair value is available based on corroborating information and our knowledge and monitoring of market conditions such as a disparity in price of comparable securities and/or non-binding broker quotes. We perform continuous reviews of the prices obtained from the pricing service. This includes evaluating the methodology and inputs used by the pricing service to ensure we determine the proper level classification of the financial instrument. Price variances, including large periodic changes, are investigated and corroborated by market data. We have reviewed the pricing methodologies of our pricing service and believe that their prices adequately consider market activity in determining fair value. In cases in which 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 on 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.
The primary basis for the valuation of limited partnership interests is financial statements prepared by the general partner. Because of the timing of the preparation and delivery of these financial statements, the use of the most recently available financial statements provided by the general partners generally result in a quarter delay in the inclusion of the limited partnership results in our Consolidated Statements of Operations. Due to this delay, these financial statements do not reflect the market conditions experienced in the fourth quarter 2009. We expect additional deterioration,
Real estate limited partnerships are recorded by the general partner at fair value based on independent appraisals and/or internal valuations. Real estate projects under development are generally valued at cost and impairment tested by the general partner. We minimize the risk of market decline by avoiding concentration in a particular geographic area and are diversified across residential, commercial, industrial and retail real estate investments.
Our actuaries review reserve estimates for both current and prior accident years using the most current claim data, on a quarterly basis, for all direct reserves except the reserves for the pre-1986 automobile massive injury claims and the workers compensation massive injury claims which are reviewed semi-annually. These massive injury reserves are reviewed semi-annually because of the relatively low number of cases and the long-term nature of these claims. For reserves that are reviewed semi-annually, our actuaries monitor the emergence of paid and reported losses in the
intervening quarters to either confirm that the estimate of ultimate losses should not change, or if necessary, perform a reserve review to determine whether the reserve estimate should change. Significant changes to the factors discussed above, which are either known or reasonably projected through analysis of internal and external data, are quantified in the reserve estimates each quarter.
The reserve review process involves a comprehensive review by our actuaries of the various estimation methods and reserve levels produced by each. These multiple reserve point estimates are reviewed by our reserving actuaries and reserve best estimates are selected. The selected reserve estimates are discussed with management. Numerous factors are considered in setting reserve levels, including, but not limited to, the assessed reliability of key loss trends and assumptions that may be significantly influencing the current actuarial indications, the maturity of the accident year, pertinent claims frequency and severity trends observed over recent years, the level of volatility within a particular line of business and the improvement or deterioration of actuarial indications in the current period as compared to prior periods.
Reserves on pre-1986 automobile massive injury reserves were increased $32.6 million in 2009. In 2009, the mortality assumptions used for pre-1986 automobile massive injury claims was changed to a 100% weighting of the disabled pensioner mortality table and gender specific mortality tables were used. The Property and Casualty Group had pre-1986 automobile massive injury reserves of $297.9 million at December 31, 2009 and $265.1 million at December 31, 2008, which are net of $165.4 million and $153.9 million of anticipated reinsurance recoverables for 2009 and 2008, respectively.
The Property and Casualty Group’s coverage with the greatest potential for variation are the massive injury reserves. The automobile no-fault law in Pennsylvania before 1986 and workers compensation policies provide for unlimited medical benefits. The estimate of ultimate liabilities for these claims is subject to significant judgment due to variations in claimant health, mortality over time and health care cost trends. Workers compensation massive injury claims have been segregated from the total population of workers compensation claims. Because the coverage related to the automobile no-fault and workers compensation claims is unique and the number of claims is about 120, the previously discussed methods are not used; rather ultimate losses are estimated on a claim-by-claim basis. An annual payment assumption is made for each of these claimants who sustained massive injuries and then projected into the future based upon a particular assumption of the future inflation rate, including medical inflation and life expectancy of the claimant. The most significant variable in estimating this liability is medical cost inflation. Changes were also made in 2009 to mortality assumptions and the discount calculation.
Our pension plan for employees is the largest and only funded defined benefit plan we offer. Our pension and other retirement benefit obligations are developed from actuarial estimates. Several statistical and other factors, which attempt to anticipate future events, are used in calculating the expense and liability related to the plans. Key factors include assumptions about the discount rates and expected rates of return on plan assets. We review these assumptions annually and modify them considering historical experience, current market conditions, including changes in investment returns and interest rates, and expected future trends.
Accumulated and projected benefit obligations are expressed as the present value of future cash payments. We discount those cash payments using the prevailing market rate of a portfolio of high-quality fixed-income debt instruments with maturities that correspond to the payment of benefits. Lower discount rates increase present values and subsequent year pension expense; higher discount rates decrease present values and subsequent year pension expense. In determining the discount rate, we performed a bond-matching study. The study developed a portfolio of non-callable bonds rated AA- or higher with at least $25 million outstanding at December 31, 2009. These bonds had maturities primarily between zero and twenty-six years. For years beyond year twenty-seven, there were no appropriate bonds maturing. In these instances, the study estimated the appropriate bond by assuming that there would be bonds available with the same characteristics as the available bond maturing in the immediately preceding year. Outlier bonds were excluded from the study. The cash flows from the bonds were matched against our projected benefit payments in the pension plan, which have a duration of about 18 years. This bond-matching study supported the selection of a 6.11% discount rate for the 2010 pension expense. The 2009 expense was based on a discount rate assumption of 6.06%. A change of 25 basis points in the discount rate assumption, with other assumptions held constant, would have an estimated $2.1 million impact on net pension and other retirement benefit costs in 2010, before consideration of expense allocation to affiliates.
In June 2009, the FASB amended the guidance for determining whether an enterprise is the primary beneficiary of a variable interest entity (VIE) by requiring a qualitative analysis to determine if an enterprise’s variable interest gives it a controlling financial interest. A primary beneficiary is expected to be identified through qualitative analysis, which looks at the power to direct activities of the VIE, including its economic performance and the right to receive benefits from the VIE that are significant. This guidance is effective for fiscal years that begin after November 15, 2009. Under the current quantitative analysis, although we hold a variable interest in it, we are not deemed to be the primary beneficiary of the Exchange, and the Exchange’s financial statements are not consolidated with ours. Under the new guidance we will be deemed to have a controlling financial interest in the Exchange, by virtue of our attorney-in-fact relationship with the Exchange, and consolidation of the Exchange in our financial statements will be required effective for our first quarter 2010 financial statements. This will require that the Exchange’s financial statements, which are currently prepared only in accordance with statutory accounting principles, be prepared in accordance with GAAP. Given the materiality of the Exchange’s operations, consolidating the Exchange’s financial statements with the Company’s will materially change our reporting entity’s assets, liabilities, revenues, expenses, related footnote disclosures and the overall presentation of management’s discussion and analysis. The Exchange’s equity will be shown as noncontrolling interests in such consolidated statements. Erie Indemnity Company’s net income and equity will be unchanged by this presentation.
Costs of management operations increased 0.5%. Commission costs decreased 0.3%, while non-commission expense increased 2.1%, driven by higher personnel, survey and underwriting costs and other operating costs in 2009 compared to 2008.
Management fee revenue is based upon the management fee rate, determined by our Board of Directors, and the direct written premiums of the Property and Casualty Group. Changes in the management fee rate can affect our revenue and net income significantly. The management fee rate was set at 25%, the maximum rate, for both 2009 and 2008. The management fee rate for 2010 has again been set at the maximum rate of 25% by our Board of Directors.
Renewal premiums written on personal lines increased 3.2% in 2009 compared to an increase of 1.6% in 2008. The 2009 increase in renewal premiums was driven by a slight increase in average premium per policy and improving policy retention ratio trends. The year-over-year average premium per policy on personal lines renewal business increased 0.1% in 2009, compared to a decrease of 1.3% in 2008. The year-over-year policy retention ratio for personal lines improved to 91.5% in 2009, from 91.4% in 2008 and 90.8% in 2007.
Private passenger auto renewal business premiums written increased 1.6% in 2009 from 2008. The private passenger auto year-over-year policy retention ratio was 91.9%, 91.8% and 91.5% in 2009, 2008 and 2007, respectively. Driving a 6.1% increase in homeowners renewal premiums written in 2009 compared to 2008 was an increase in year-over-year policyholder retention ratio to 91.2% in 2009, compared to 91.1% and 90.3% in 2008 and 2007, respectively.
Service agreement revenue includes service charges we collect from policyholders for providing extended payment terms on policies written by the Property and Casualty Group and late payment and policy reinstatement fees. The service charges are fixed dollar amounts per billed installment. Service agreement revenue totaled $34.8 million, $32.3 million and $29.7 million in 2009, 2008 and 2007, respectively. Service agreement revenue increased by $5.8 million in 2009 and $2.9 million in 2008 due to the implementation of late payment and policy reinstatement fees that became effective in March 2008. These increases were offset somewhat by continued shifts to the no-fee, single payment plan driven by a discount in pricing offered for paid-in-full policies as well as consumers’ desire to not incur service charges.
Commissions in 2009 decreased 0.3% as a result of a $12.7 million decrease in the estimate for agent bonuses, offset by a $11.1 million increase in scheduled rate commissions.
All other operating costs increased $1.9 million primarily as a result of increased contract labor costs related to various technology initiatives.
Scheduled and accelerated rate commissions - Scheduled rate commissions were impacted by a 1.6% increase in the direct written premiums of the Property and Casualty Group in 2009. Also, commission rates were increased for certain commercial lines new business premiums effective in July 2008, which added $2.1 million to 2009 scheduled rate commissions. In 2008, these commercial rate increases added $1.5 million to scheduled rate commissions. Also in 2008, an increase in workers compensation commission rates, which became effective in the latter half of 2007 in certain states, added $2.8 million of commission expense.
Accelerated rate commissions are offered under specific circumstances to certain newly-recruited agencies for their initial three years of operation. Accelerated rate commissions decreased in 2009 as existing accelerated commission contracts are expiring. This is reflective of the fact that although new agency appointments continue, the number of such appointments has been declining. We appointed 120 new agencies in 2009, 156 in 2008 and 214 in 2007.
Promotional incentives and other bonuses - In July 2006, an incentive program was implemented that paid a bonus to agents for each qualifying new private passenger auto policy issued to stimulate growth. A tiered payout structure was introduced for this bonus effective in June 2008. This tiered bonus structure resulted in additional commission expense of $4.7 million in 2009 and $3.2 million in 2008. This bonus structure ended on January 31, 2010. A new commission structure became effective February 1, 2010 which will increase commissions for qualifying new private passenger auto policies.
Survey and underwriting costs increased $2.9 million in 2009. A 7.5% increase in submitted applications for potential policyholders contributed to higher underwriting costs. All other operating costs increased 3.3%, or $1.9 million, in 2009 driven by a $2.7 million increase primarily in contract labor costs related to various technology initiatives. This increase is net of $5.7 million of capitalized contract labor costs.
Future trends-cost of management operations - The cost structure and competitive position of the Property and Casualty Group is based on many factors including price considerations, service levels, ease of doing business, product features and billing arrangements. Pricing of Property and Casualty Group policies is directly affected by the cost structure of the Property and Casualty Group and the underlying costs of sales, underwriting activities, policy issuance activities and billing arrangements performed by us for the Property and Casualty Group. Management’s objective is to better align our growth in costs to our growth in premium over the long-term. We will continue our various information technology initiatives aimed at improving our operating performance in 2010 and beyond.
The loss and loss expense ratio related to the current accident year, excluding catastrophe losses, was 68.4% in 2009, which was 0.7 points higher than the 67.7% in 2008.
In 2009, the Property and Casualty Group’s underwriting income was reduced by a net $50.5 million related to the write-off of assumed involuntary reinsurance premium related to the North Carolina Beach and Coastal Plans deemed uncollectible as a result of recent state legislation. Our $2.8 million share of this write off is reflected in policy acquisition and other underwriting expense and contributed 1.3 points to our 2009 GAAP combined ratio.
The GAAP loss and LAE ratio, expressed as a percentage, is the ratio of losses and loss expenses incurred to earned premiums for our property/casualty insurance subsidiaries.
The adjusted statutory combined ratio removes the profit margin on the management fee we earn from the Property and Casualty Group.
The personal lines adjusted statutory combined ratio increase in 2009 over 2008 was primarily impacted by reserve increases resulting from assumption changes and increasing frequency trends. In 2008, favorable development on prior accident year loss reserves was experienced on automobile bodily injury and uninsured/underinsured motorist bodily injury.
The commercial lines adjusted statutory combined ratio decrease in 2009 over 2008 is primarily due to reserve decreases resulting from assumption changes combined with the settlement of eight massive injury workers compensation claims. Impacting 2008 was one large fire claim in Pennsylvania and losses related to Hurricane Ike in Ohio, Pennsylvania and Indiana.
The following table provides the details of the prior year loss reserve development for our wholly-owned property/casualty insurance subsidiaries:
Negative amounts represent a redundancy (decrease in reserves) while positive amounts represent a deficiency (increase in reserves).
Direct - Our 5.5% share of the Property and Casualty Group’s favorable development of prior accident year direct losses, after removing the effects of salvage and subrogation recoveries, was $1.2 million in 2009 and improved the combined ratio by 0.6 points. Driving the prior accident year development are $7.3 million of favorable development related to workers compensation reserves offset by adverse development of $4.3 million related to the pre-1986 automobile massive injury reserves. The favorable workers compensation development was a function of 1) the settlement of several massive injury workers compensation claims, 2) changes to mortality assumptions and 3) a change in the payout patterns used in the calculation to discount workers compensation reserves. The adverse development on the pre-1986 automobile massive injury reserves was the result of changes made to the mortality assumption, specifically the use of gender specific mortality tables, coupled with increasing frequency trends. Adverse development was also experienced on the commercial multi-peril line in 2009 as a result of some reserve strengthening and the outcome of certain court decisions.
Assumed reinsurance - The Property and Casualty Group experienced favorable development of prior accident year loss reserves on its assumed reinsurance business of $38.1 million, $66.8 million and $65.9 million in 2009, 2008 and 2007, respectively. Our 5.5% share of this development was $2.1 million, $3.7 million and $3.6 million in 2009, 2008 and 2007, respectively. The favorable development was due to less than anticipated growth in involuntary reinsurance and, to a lesser extent, reductions in reserve levels related to World Trade Center (WTC) losses.
Ceded reinsurance - Ceded reinsurance reserves are primarily related to the pre-1986 automobile massive injury claims. As mentioned in the discussion of direct business above, the pre-1986 automobile massive injury reserves increased in 2009 due to assumption changes and frequency trends. These reserve increases drove the corresponding increase in the 2009 receivable from the ceded reinsurer.
We incurred net realized gains on investments in 2009 of $10.4 million compared to losses of $43.5 million in 2008. Our common stock trading portfolio contributed $10.9 million in valuation adjustment gains to the 2009 results, compared to $21.7 million in valuation adjustment losses to the 2008 results.
Equity in losses of limited partnerships were $76.1 million in 2009 compared to gains of $5.7 million in 2008, primarily as a result of fair value declines in our real estate limited partnerships.
Equity in earnings of EFL was $5.6 million in 2009 compared to losses of $14.6 million in 2008, driven primarily by lower impairment charges. Our share of impairment charges recorded by EFL totaled $5.0 million in 2009 compared to $18.1 million in 2008.
The components of equity in (losses) earnings of limited partnerships are as follows:
Limited partnership earnings pertain to investments in U.S. and foreign private equity, real estate and mezzanine debt partnerships. Valuation adjustments are recorded to reflect the fair value of limited partnerships. These adjustments are recorded as a component of equity in earnings of limited partnerships in the Consolidated Statements of Operations. Private equity and mezzanine debt limited partnerships generated earnings, excluding valuation adjustments, of $0.1 million, $13.6 million and $21.6 million in 2009, 2008 and 2007, respectively. Real estate limited partnerships included losses of $0.5 million, and earnings of $13.1 million and $15.6 million in 2009, 2008 and 2007, respectively. We experienced a decline in earnings as a result of asset value reductions recognized in 2009 due to adverse market conditions resulting in lower than normal transaction volume and, subsequently, lower sales prices and gains on sales of investments. Limited partnership earnings tend to be cyclical based on market conditions, the age of the partnership and the nature of the investments. Generally, limited partnership earnings are recorded by us on a quarter lag from financial statements we receive from our general partners. As a consequence, earnings from limited partnerships reported at December 31, 2009 do not reflect investment valuation changes that may have resulted from the financial markets and the economy in general in the fourth quarter of 2009.
Our $5.6 million equity in earnings of EFL in 2009 included lower impairment charges compared to 2008. EFL recorded pre-tax impairment charges of $22.9 million in 2009, of which our share was $5.0 million before tax. EFL’s impairment charges were $83.5 million in 2008, of which our share was $18.1 million before tax. EFL’s net income was positively impacted by a reduction in the deferred tax valuation allowance of $18.9 million in 2009. The net loss in 2008 was negatively impacted by $32.7 million due to the establishment of a deferred tax valuation allowance. EFL’s valuation allowance at December 31, 2009 was $4.4 million. The allowance was established because it is more likely than not that the related deferred tax asset will not be realized.
We continually review the available-for-sale debt and equity portfolios 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. 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 costs. With the issuance of new impairment guidance for debt securities in the second quarter of 2009, we further analyze debt securities 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 credit-related impairments are recorded in other comprehensive income. Prior to the second quarter of 2009, there was no differentiation between impairments related to credit loss and those related to other factors and declines in fair values of debt securities were deemed other-than-temporary if we did not have the intent and ability to hold a security to recovery. For available-for-sale equity securities, a charge is recorded in the Consolidated Statement of Operations for positions that have experienced other-than-temporary impairments due to credit quality or other factors. (See “Investment Operations” section herein.)
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. At December 31, 2009, the net unrealized gain on fixed maturities, net of deferred taxes, amounted to $14.2 million, compared to a $22.3 million loss at December 31, 2008.
Our equity securities consist of common stock and nonredeemable preferred stock. Investment characteristics of common stock and nonredeemable preferred stock differ substantially from one another. Our nonredeemable preferred stock portfolio provides a source of current income that is competitive with investment-grade bonds.
The following tables present an analysis of the fair value of our preferred and common stock securities by sector at December 31:
Our equity securities are carried at fair value on the Consolidated Statements of Financial Position. At December 31, 2009, the unrealized gain on available-for-sale equity securities, net of deferred taxes, amounted to $1.9 million, compared to a $3.0 million loss at December 31, 2008.
During 2009, investments in limited partnerships decreased $64.2 million to $235.0 million due to current market conditions. Mezzanine debt and real estate limited partnerships, which comprise 63.6% of the total limited partnerships, produce a more predictable earnings stream while private equity limited partnerships, which comprise 36.4% of the total limited partnerships, tend to provide a less predictable earnings stream but the potential for greater long-term returns. At December 31, 2009, our investments in limited partnerships represented 24.0% of total investments, compared to 31.4% at December 31, 2008.
Recoverable amounts are reflected as an asset on our Statements of Financial Position. The direct and assumed loss and loss expense reserves by major line of business and the related amount recoverable under the intercompany pooling arrangement are presented as follows:
Includes $778.0 million in 2009 and $777.8 million in 2008 due from the Exchange.
It is anticipated that these massive injury claims will require payments over the next 30 to 40 years. In 2009, we changed our medical inflation rate assumption for these reserves to an 8% annual increase grading down 0.5% per year to an ultimate rate of 5%. In 2008, this assumption was a 9% annual increase grading down 1% after the first year, then grading down 0.5% per year to an ultimate rate of 5%. The impact on the massive injury liability reserves due to the change in our medical inflation rate assumption in 2009 resulted in a reserve reduction of $25.6 million for the Property and Casualty Group, of which our property/casualty subsidiaries’ share was $1.4 million. In 2009, we changed our mortality rate assumption to give 100% weighting to the disabled pensioner mortality table by gender to more appropriately weigh male versus female life expectancies. In 2008, this assumption gave 75% weighting to our own mortality experience and 25% weighting to the male-female combined disabled pensioner mortality table. The impact on the massive injury liability reserves due to the change in our mortality rate assumption in 2009 resulted in a reserve increase of $73.3 million for the Property and Casualty Group, of which our property/casualty subsidiaries’ share was $4.0 million. Our share of the massive injury claim payments made during 2009, 2008 and 2007 was $0.9 million, $0.8 million and $1.0 million, respectively.
Liquidity is a measure of a company’s ability to generate sufficient cash flows to meet the short- and long-term cash requirements of its business operations. Our liquidity requirements have been met primarily by funds generated from management operations, the net cash flows of our insurance subsidiaries 5.5% participation in the underwriting results of the reinsurance pool with the Exchange, and investment income from nonaffiliated investments. Cash provided from these sources is used primarily to fund the costs of management operations including salaries and wages and commissions, pension plans, share repurchases, dividends to shareholders and the purchase and development of information technology. We expect that our operating cash needs will be met by funds generated from operations. When cash provided by operating activities is in excess of our operating cash needs, we may use this excess to fund our investment portfolios or share repurchase activities. When funding requirements exceed operating cash flows, our investment portfolios may be used as a funding source. Continuing volatility in the financial markets presents challenges to us as we occasionally access our investment portfolio as a source of cash. Some of our fixed income investments, despite being publicly traded, are illiquid due to credit market conditions. Further volatility in these markets could impair our ability to sell certain of our fixed income securities or cause such securities to sell at deep discounts. Additionally, our limited partnership investments are illiquid. We believe we have sufficient liquidity to meet our needs from other sources even if market volatility persists throughout 2010. See
We have audited Erie Indemnity Company’s internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Erie Indemnity Company’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Erie Indemnity Company at December 31, 2009 and 2008, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2009, 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.
As discussed in Note 2 to the consolidated financial statements, in 2009 the Company changed its method of accounting for recognizing other-than-temporary impairment charges for its debt securities in connection with the adoption of the revised Financial Accounting Standards Board’s other-than-temporary impairment model. As discussed in Note 5 to the consolidated financial statements, in 2008 the Company changed its method of accounting for its common stock portfolio in connection with the adoption of the fair value option.
The Exchange and its wholly-owned subsidiary, Flagship City Insurance Company (“Flagship”) and the Indemnity’s wholly-owned subsidiaries, Erie Insurance Company (“EIC”), Erie Insurance Company of New York (“ENY”) and the Erie Insurance Property and Casualty Company (“EPC”), comprise the Property and Casualty Group. The Property and Casualty Group is a regional insurance group operating in 11 Midwestern, Mid-Atlantic, and Southeastern states and the District of Columbia. The Property and Casualty Group primarily writes personal auto insurance, which comprises 48% of its 2009 direct premiums.
The Indemnity also owns 21.6% of the common stock of the Erie Family Life Insurance Company (“EFL”), an affiliated life insurance company; the Exchange owns the remaining 78.4%. EFL underwrites and sells nonparticipating individual and group life insurance policies and fixed annuities.
Fixed income and redeemable preferred stock (debt securities) are evaluated monthly for other-than-temporary impairment loss. For debt securities that have experienced a decline in fair value and we intend to sell or for which it is
more likely than not we will be required to sell the security before recovery of its amortized cost, an other-than-temporary impairment is deemed to have occurred and is recognized in earnings.
Debt securities that have experienced a decline in fair value and 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 other-than-temporary.
If a decline is deemed to be other-than-temporary, an assessment is made to determine the amount of the total impairment related to a credit loss and that related to all other factors. Consideration is given to all available information relevant to the collectibility of the security in this determination. If the entire amortized cost basis of the security will not be recovered, a credit loss exists. Currently, we have the intent to sell all of our securities that have been determined to have a credit-related impairment. As a result, the entire amount of the impairment has been recognized in earnings. If we had securities with credit impairments that we did not intend to sell, the non-credit portion of the impairment would have been recorded in other comprehensive income.
Limited partnerships - Limited partnerships include U.S. and foreign private equity, real estate and mezzanine debt investments. The private equity limited partnerships invest primarily in small- to medium-sized companies. The general partners for our limited partnerships determine the market value of investments in the partnerships including any other-than-temporary impairments of these individual investments.
For real estate limited partnerships, the general partners record these at fair value based on an independent appraisal or internal estimates of fair value.
The liability for losses and loss expenses includes estimates for claims that have been reported and those that have been incurred but not reported, and estimates of all expenses associated with processing and settling these claims. Estimating the ultimate cost of future losses and loss expenses is an uncertain and complex process. This estimation process is based significantly on 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.
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
On July 1, 2009, we adopted new accounting guidance related to the codification of accounting standards and the hierarchy of GAAP established by the Financial Accounting Standards Board (the “FASB”). This accounting guidance established two levels of GAAP, authoritative and nonauthoritative. The FASB Accounting Standards Codification (the “Codification”) is the source of authoritative, nongovernmental GAAP, except for rules and interpretive releases of the SEC, which are also sources of authoritative GAAP for SEC registrants. All other accounting literature is nonauthoritative. There was no impact on our consolidated financial statements upon adoption of this standard.
FASB ASC 820, Fair Value Measurements and Disclosures, provides additional guidance for estimating fair value when the volume and level of activity for the asset or liability have significantly decreased in relation to normal market activity. This guidance states a reporting entity shall evaluate circumstances to determine whether the transaction is orderly based on the weight of the evidence. The additional disclosures required by this guidance, including the inputs and valuation techniques used to measure fair values and any changes in such, have been included in Note 5.
On April 1, 2009, we adopted new accounting guidance under FASB ASC 320, Investments - Debt and Equity Securities. This guidance amended the other-than-temporary impairment (OTTI) model for debt securities and requires that credit-related losses and securities in an unrealized loss position that we intend to sell be recognized in earnings, with the remaining decline recognized in other comprehensive income. Additionally, this accounting guidance modified the presentation of OTTI in the statement of operations with the total OTTI presented along with an offset for the amount of OTTI recognized in other comprehensive income. Disclosures include further disaggregation of securities, methodology, inputs related to credit-related loss impairments and a rollforward of credit-related loss impairments. The adoption of this guidance required a cumulative effect adjustment to reclass previously recognized non-credit other-than-temporary impairments from retained earnings to other comprehensive income. The net impact of the cumulative effect adjustment increased retained earnings and decreased other comprehensive income by $6.7 million, net of tax. Disclosures regarding our impairment methodology are included in this note under the caption Investments. The remaining disclosures regarding credit and non-credit related impairments have been provided in Note 6.
In 2007, the FASB issued guidance under FASB ASC 325, Financial Instruments, that gave us the irrevocable option to report selected financial assets and liabilities at fair value and established presentation and disclosure requirements. We adopted the fair value option for our common stock portfolio. Beginning January 1, 2008, all changes in fair value of our common stock are recognized in earnings as they occur. The net impact of the cumulative effect adjustment for our common stock portfolio on January 1, 2008 increased retained earnings and reduced other comprehensive income by $11.2 million, net of tax. See also Note 5.
In 2006, FASB ASC 820, Fair Value Measurements and Disclosures, was updated to provide guidance for using fair value to measure assets and liabilities as well as enhances disclosures about fair value measurements which became effective for us on January 1, 2008. The standard did not expand the use of fair value in any new circumstances and thus, did not have an impact on our financial position, results of operations or cash flows. The guidance established a fair value hierarchy that prioritizes the inputs for valuation techniques used to measure fair value into three levels. The required disclosures concerning inputs used to measure fair value are included in Note 5.
Basic earnings per share are calculated under the two-class method which allocates earnings to each class of stock based on its dividend rights. Class B shares are convertible into Class A shares at a conversion ratio of 2,400 to 1. See Note 13. Class A diluted earnings per share are calculated under the if-converted method which reflects the conversion of Class B shares and the effect of a potentially dilutive outstanding employee stock-based award and awards not yet vested related to the outside directors’ stock compensation plan. The 2007 calculation also includes the effect of potentially dilutive outstanding employee stock-based awards under the pre-2004 long term incentive plan. See Note 11.
includes only run-off activity of the assumed reinsurance business. Insurance provided in the insurance underwriting operations consists of personal and commercial lines and is sold by independent agents. Personal lines consist primarily of private passenger auto and are marketed to individuals, and commercial lines are marketed to small- and medium-sized businesses. The performance of personal lines and commercial lines is evaluated by our management based upon the underwriting results as determined under statutory accounting principles (SAP) for the total pooled business of the Property and Casualty Group.
Quoted prices for identical instruments in active markets not subject to adjustments or discounts.
Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.
Transfers in and out of Level 3 are attributable to changes in the availability of market observable information for individual securities within the respective categories.
The following table represents the fair value measurements on a recurring basis for our invested assets by major category and level of input:
The following table sets forth the fair value of our fixed maturity and preferred stock securities by pricing source as of December 31, 2009:
The following tables summarize the cost and fair value of available-for-sale securities at December 31, 2009 and 2008:
There were no sales of limited partnerships in 2009. We sold our interest in ten partnerships in 2008 and two partnerships in 2007 which generated net realized gains.
In considering if fixed maturity securities were credit impaired some of the factors considered include: potential for the default of interest and/or principal, level of subordination, collateral of the issue, compliance with financial covenants, credit ratings and industry conditions. We have the intent to sell all credit-impaired fixed
maturity securities, therefore the entire amount of the impairment charges were included in earnings and no non-credit impairments were recognized in other comprehensive income. Prior to the second quarter of 2009 when new impairment guidance was issued for debt securities, the impairment policy for fixed maturities was consistent with that of equity securities. See also Note 2.
Equity in losses from limited partnerships as reported in the Consolidated Statements of Operations totaled $76.1 million in 2009 compared to earnings of $5.7 million and $59.7 million in 2008 and 2007, respectively.
Per the limited partner financial statements, total partnership assets were $35.5 billion and total partnership liabilities were $8.2 billion at December 31, 2009 (as recorded in the September 30, 2009 limited partnership financial statements). For the twelve month period comparable to that presented in the preceding table (fourth quarter of 2008 and first three quarters of 2009), total partnership valuation adjustment losses were $5.0 billion and total partnership net loss was $0.5 billion.
We previously participated in a program whereby marketable securities from our investment portfolio were lent to independent brokers or dealers based on, among other things, their creditworthiness, in exchange for collateral initially equal to 102% of the value of the securities on loan and are thereafter maintained at a minimum of 100% of the fair value of the securities loaned. The process of terminating this program was completed in 2009. We had loaned securities included as part of our invested assets with a fair value of $17.5 million at December 31, 2008.
The following presents condensed financial information for EFL on a U.S. GAAP basis:
Net income in 2009 was positively impacted by a reduction in the deferred tax valuation allowance of $18.9 million. A deferred tax valuation allowance of $32.8 million was recorded in the Statements of Operations for 2008 related to the more significant impairment charges and contributed to the net loss reported in 2008.
Comprehensive income was positively impacted by the $26.9 million cumulative effect of implementing new other-than-temporary impairment guidance in the second quarter of 2009. Additionally, EFL experienced unrealized gains, after tax of $89.6 million in 2009 which contributed to the increase in comprehensive income and investments. The comprehensive loss for 2008 included unrealized losses after tax of $70.2 million resulting from the 2008 market conditions.
Total shareholders’ equity increased over $197 million at December 31, 2009 compared to December 31, 2008. The main factors driving this increase were $89.6 million in unrealized gains, net of tax, the capital contribution of $55 million, the cumulative effect adjustment of $26.9 million and net income of $25.9 million.
Our pension plans consist of a noncontributory defined benefit pension plan covering substantially all employees and an unfunded supplemental employee retirement plan (SERP) for certain members of executive and senior management of the Group. The pension plans provide benefits to covered individuals satisfying certain age and service requirements. The defined benefit pension plan and SERP provide benefits through a final average earnings formula and a percent of average monthly compensation formula, respectively.
The liabilities for the plans described in this note are presented in total for all employees of the Group. The gross liability for postretirement benefits is presented in the Consolidated Statements of Financial Position as employee benefit obligations. Approximately 50% of postretirement benefit expenses are reimbursed to us from the Exchange and EFL.
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 was 6.11% for 2009 and was based on a bond-matching study that compared projected pension plan benefit flows to the cash flows from a comparable portfolio of fixed maturity instruments rated AA- or better with duration similar to plan liabilities. This same bond matching methodology was used in 2008 and 2007. The change in the discount rate to 6.06% in 2008 from 6.62% in 2007 was due to the turmoil in the fixed income markets at the end of 2008. The approach used to determine the long-term rate of return assumption derives expected future returns for each asset category based on applicable indices and their historical relationships under various market conditions. These expected future returns are then weighted based on our target asset allocation percentages for each asset category.
There was a shift in our target asset allocation percentage in late 2009 to 60% equity securities and 40% fixed income securities compared to 2008’s target of 65% equity securities and 35% fixed income securities.
The 2007 settlements related to the annuity purchases and lump sum payouts made to three participants who retired in 2006.
The cumulative net actuarial loss was offset in 2009 by an actuarial gain resulting from actual investment returns that were greater than expected. Also contributing to the gain were assumption changes made based on actual experience, such as the decrease in the assumed rate of compensation increase. The 2008 actuarial loss was primarily due to a significant difference in the plan’s actual investment returns in 2008 from the expected returns assumed and the decrease in the discount rate assumption used to estimate the future benefit obligations to 6.06% in 2008 from 6.62% in 2007. The component of the $144.6 million actuarial loss produced in 2008 that related to the difference between actual and expected investment returns was $106.1 million. Recognition of this loss is being deferred over the subsequent four year period. The 2007 actuarial gain was primarily due to an increase in the discount rate assumption used to estimate the future benefit obligation from 6.25% in 2006 to 6.62% in 2007.
The charges recognized as amendments were the result of factoring in the prior service cost for six new plan participants in 2009.
Actuarial loss was due to the difference in the actual return on plan assets versus the expected return on plan assets, driven by the volatile market conditions experienced in 2008 and the decrease in the discount rate to 6.06% in 2008 from 6.62% in 2007.
The estimated net actuarial loss and prior service cost for the pension plans that will be amortized from accumulated other comprehensive income into net periodic benefit cost during 2010 are $3.7 million and $0.7 million, respectively.
Certain members of executive management were paid their full SERP benefits in a lump sum payment in December 2008, after which time no additional SERP benefits will accrue for them.
This category seeks to provide excess returns relative to an international small cap index, while matching the regional weights of the index.
This category seeks to generate returns that exceed the Barclays Capital US Long Corporate Bond A or Better Index investing in US Corporate Bonds with an emphasis on long duration bonds rated A or better.
Estimates of fair values of the pension plan assets are obtained primarily from a nationally recognized pricing service. 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 pricing service. Our Level 2 category includes commingled pools. Estimates of fair values for securities held by our commingled pools are obtained primarily from the pricing service. The methodologies used by the pricing service that support a Level 2 classification of a financial instrument include multiple verifiable, observable inputs including benchmark yields, reported trades, broker/dealer quotes, issuers spreads, two-sided markets, benchmark securities, bids, offers and reference data. There were no Level 3 investments during 2009.
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. At December 31, 2009 and 2008, the accumulated benefit obligation associated with these benefits was $8.0 million and $8.5 million, respectively. This plan is funded only as claims are incurred. During 2009, we recognized an increase in other comprehensive income of $0.5 million. During 2008, we recognized a decrease in other comprehensive income (loss) of $0.5 million. Periodic benefit costs, before reimbursements from our affiliates, were $0.3 million, $0.2 million and $0.4 million in 2009, 2008 and 2007, respectively.
The annual incentive plan is a bonus plan that annually pays cash bonuses to our executive, senior and regional vice presidents.
The long-term incentive plan (LTIP) is a performance based incentive plan designed to reward executive, senior and regional vice presidents who can have a significant impact on our long-term performance.
At December 31, 2009, the awards for the 2007-2009 performance period were fully vested in accordance with the 2004 LTIP plan. The awards for this performance period will be calculated upon receipt of final financial information for the peer group. The estimated award based on the peer group information as of September 30, 2009, is 49,552 shares. The grant price will be the average of the high and low stock price on the date the award is paid. Our stock price as of January 29, 2010, was $39.00.
The deferred compensation plans are arrangements for our executive, senior and regional vice presidents whereby the participants can elect to defer receipt of a portion of their compensation until a later date. Supplemental employee contributions to the deferred compensation plan are deferrals that cannot be credited to our tax-qualified 401(k) plan because they exceed the annual contribution or compensation limits of that plan. However, these contributions are credited with a company-matching contribution using the same formula as in our 401(k) plan. The
deferred compensation plan for directors allows them to defer receipt of a portion of their director and meeting fees until a later date. Employees or directors participating in the respective plans select hypothetical investment funds for their deferrals and are credited with the hypothetical returns generated.
The awards, payments, deferrals and liabilities under the deferred compensation, annual and long-term incentive plans for officers and directors were as follows for the years ended December 31. The gross liabilities are presented separately in the Consolidated Statements of Financial Position, while allocations to affiliates are included in reinsurance recoverable from Erie Insurance Exchange on unpaid losses and loss expenses until such time as payments are made to participants under the plan.
We have a stock compensation plan for our outside directors to further align the interests of directors with shareholders by providing for a portion of annual compensation for the directors’ services in shares of our Class A common stock. Each director vests in the grant 25% every three months over the course of a year. Dividends paid by us are reinvested into each director’s account with additional shares of our Class A common stock. In 2009, the annual charge related to this plan totaled $0.4 million. In 2008, compensation expense for this plan was offset by market value adjustments to the directors’ accounts resulting in a net credit of $0.2 million. In 2007, the annual charge related to this plan totaled $0.4 million.
The deferred income tax benefit in 2009 was driven by limited partnership losses. The deferred income tax benefit in 2008 was primarily driven by impairments and unrealized losses on common stock. The more significant impairment losses in 2008 related to bonds and preferred stocks in the financial services industry.
Deferred tax asset valuation allowances of $1.5 million and $1.3 million were recorded at December 31, 2009 and December 31, 2008, respectively, related to impairments on investments where it is more likely than not that the related deferred tax asset will not be realized.
We have one uncertain income tax position for which a current liability was recorded. As a related temporary tax difference was also recognized, there was no impact on our operations or financial position. We recognize interest related to our one uncertain tax position in income tax expense. Accrued estimated interest on our unrecognized tax benefit was $0.3 million and $0.4 million at December 31, 2009 and 2008, respectively. The IRS has examined tax filings through 2005 and is currently examining our federal income tax returns for 2006 and 2007. We do not currently estimate that our unrecognized tax benefits will change significantly in the next 12 months.
A stock repurchase program was authorized for our outstanding Class A common stock beginning January 1, 2004. In May 2009, our Board of Directors approved a continuation of the stock repurchase program through June 30, 2010. Treasury shares are recorded in the Consolidated Statements of Financial Position at cost. Shares repurchased under this plan totaled 0.1 million at a total cost of $3.1 million for 2009 and 2.1 million at a total cost of $102.0 million during 2008. Cumulative shares repurchased under this plan through 2009 totaled 11.8 million at a total cost of $613.2 million.
The following table provides a reconciliation of beginning and ending loss and loss expense liability balances for our wholly-owned property/casualty insurance subsidiaries for the years ended December 31:
Loss reserves are set at full expected cost, except for workers compensation loss reserves, which have been discounted using an interest rate of 2.5% for all periods presented. This discounting reduced unpaid losses and loss expenses by $7.5 million, $5.4 million and $5.5 million at December 31, 2009, 2008 and 2007, respectively. The increased discount in 2009 was the result of segregating large individual workers compensation claims that have longer payout patterns in the discount calculation. The reserves for losses and loss expenses are reported net of receivables for salvage and subrogation of $7.3 million, $6.7 million and $6.8 million at December 31, 2009, 2008 and 2007, respectively.
Favorable development in 2009 on prior year accident reserves is primarily due to changes in our mortality rate and medical cost assumptions in our workers compensation line of business and the change in the workers compensation discount discussed above. Driving the favorable development in 2008 and 2007 on prior year accident reserves were improved frequency and severity trends for automobile bodily injury and uninsured/underinsured motorist bodily injury claims.
A management fee is charged to the Exchange for services we provide under subscriber’s agreements with policyholders of the Exchange. The fee is a percentage of direct written premium of the Property and Casualty Group. This percentage rate is adjusted periodically by our Board of Directors but cannot exceed 25%. The effective management fee rate charged the Exchange was 25% in 2009, 2008 and 2007. The Board of Directors elected to maintain the fee at 25% beginning January 1, 2010.
We are due $25 million from EFL in the form of a surplus note that was issued in 2003. The note may be repaid only out of unassigned surplus of EFL. Both principal and interest payments are subject to prior approval by the Pennsylvania Insurance Commissioner. The note bears an annual interest rate of 6.70% and will be payable on demand on or after December 31, 2018, with interest scheduled to be paid semi-annually. EFL paid annual interest to us of $1.7 million in 2009, 2008 and 2007.
Financial instruments could potentially expose us to concentrations of credit risk, including unsecured receivables from the Exchange. A large majority of our revenue and receivables are from the Exchange and affiliates. See also Note 17.
The Exchange underwrites a broad line of personal and commercial insurance, including private passenger auto, homeowners and commercial multi-peril insurance. Direct written premiums of the Exchange totaled $3.2 billion in 2009 and $3.1 billion in both 2008 and 2007. These premiums, along with investment income are the major sources of cash that support the operations of the Exchange. Policyholders’ surplus was $4.5 billion, $4.0 billion and $4.8 billion at December 31, 2009, 2008 and 2007, respectively.
In the determination as to whether we are the primary beneficiary we consider the variability in the management fee as well as the variability in underwriting results that would accrue to us under the pooling arrangement in determining the residual returns from the Exchange. The variability is modeled using our stochastic modeling software assigning probabilities to the possible outcomes and determining a probability in the weighted result. The outcomes are calculated using discounted cash flows assuming a discount rate of 5%. Gross cash flows modeled assume a run-off of existing insurance policies and investments. To evaluate circumstances as of the determination date, no new insurance policies are assumed to be written after the evaluation date. We do not include new
We calculate the total variability of the Exchange results and then determine the amount of variability absorbed by us. In the modeled result we absorb approximately 3% of the total variability of the Exchange at December 31, 2009 which is well below the majority and supports the conclusion that the Company is not the primary beneficiary of the Exchange.
We participate in the underwriting results of the Exchange through the pooling arrangement in which our insurance subsidiaries have a 5.5% participation. If the Exchange were to default, our insurance subsidiaries would be liable for the policies that they wrote directly. Our property/casualty insurance subsidiaries wrote approximately 16% of the direct written premiums of the Property and Casualty Group in 2009.
We have exposure to a concentration of credit risk related to the unsecured receivables due from the Exchange for its management fee and cost reimbursements. See Note 16.
We have not provided financial or other support to the Exchange for the reporting periods presented. At December 31, 2009, there are no implicit or explicit arrangements that would require us to provide future support to the Exchange. We are not liable if the Exchange were to be in violation of its debt covenant or were unable to meet its obligation for unfunded commitments to limited partnerships.
The financial statements of the Exchange are prepared in accordance with statutory accounting principles (SAP) prescribed by the Commonwealth of Pennsylvania. The Exchange is not required to prepare financial statements in accordance with GAAP. Financial statements prepared under statutory accounting principles focus on the solvency of the insurer and generally provide a more conservative approach than under GAAP. Differences between SAP and GAAP include the valuation of investments, deferred policy acquisition cost assets, deferred tax assets and unearned subscriber fees. Fixed maturities investments are primarily carried at amortized cost and subject to impairment accounting. At December 31, 2009, the market value of fixed maturities was $250.3 million more than the carrying cost. Equity securities are primarily carried at market value. At December 31, 2009 the market value of the equity securities portfolio totaled $2.2 billion. Our limited partnerships are recorded based on the Exchange’s interest in the underlying GAAP equity of the partnership. At December 31, 2009, the value of the limited partnerships was $1.1 billion.
The selected financial data below is derived from the Exchange’s financial statements prepared in accordance with Statutory Accounting Principles (SAP) required by the National Association of Insurance Commissioners’ (NAIC) Accounting Practices and Procedures Manual, as modified to include prescribed practices of the Insurance Department of the Commonwealth of Pennsylvania. In the opinion of management, all adjustments, consisting only of normal recurring accruals, considered necessary for a fair presentation, have been included. The condensed financial data set forth below represents the Exchange’s share of underwriting results after accounting for intercompany pool transactions.
During 2009 the Exchange recognized impairment charges of $38.9 million on fixed maturities, $82.3 million on common stock and $50.0 million on preferred securities, and $270.2 million on limited partnerships. As with our investments, the Exchange’s investment portfolio in 2009 and 2008 was impacted by declines in the value of securities related to current market conditions. Driving the Exchange’s 2008 investment losses were impairment charges of $197.9 million on fixed maturities, $245.0 million on common stock, $220.2 million on preferred securities and $81.2 million on limited partnerships. Under statutory accounting, deferred tax assets on realized capital losses from impairments of investments are reflected as a change in surplus rather than in deferred income tax provision on the statement of operations. Deferred tax assets established related to impairment charges totaled $154.5 million in 2009 and $260.5 million in 2008.
Accounting principles used to prepare statutory financial statements differ from those used to prepare financial statements under GAAP. The statutory financial statements of EPC and EIC are prepared in accordance with accounting practices prescribed by the Pennsylvania Insurance Department. ENY prepares its statutory financial statements in accordance with accounting practices prescribed by the New York Insurance Department. Prescribed SAP include state laws, regulations, and general administration rules, as well as a variety of publications from the NAIC.
Combined shareholders’ equity including amounts reported by our property/casualty insurance subsidiaries on the statutory basis was $877.3 million and $798.3 million at December 31, 2009 and 2008, respectively. Combined net income, including amounts reported by our property/casualty insurance subsidiaries on a statutory basis, was $109.4 million, $58.4 million and $210.6 million for 2009, 2008 and 2007, respectively.
The amount of dividends EFL, a Pennsylvania-domiciled life insurer, can pay to its shareholders without the prior approval of the Pennsylvania Insurance Commissioner is limited by statute to the greater of: (a) 10% of its statutory surplus as shown on its last annual statement on file with the commissioner, or (b) the net income as reported on its last annual statement, but shall not include pro-rata distribution of any class of the insurer’s own securities. Accordingly, our share of the maximum dividend payout which may be made in 2009 without prior Pennsylvania Commissioner approval is $3.7 million. There were no dividends paid to us in 2009, 2008 or 2007.
We have contractual commitments to invest up to $68.8 million related to our limited partnership investments at December 31, 2009. These commitments are split between private equity securities of $31.8 million, real estate activities of $21.4 million and mezzanine debt securities of $15.6 million. These commitments will be funded as required by the partnerships’ agreements.
respectively. Fourth quarter was also impacted by $18.4 million of realized losses on common stock and $17.4 million related to market value adjustments on limited partnerships.