ability to maintain uninterrupted business operations and difficulties with technology or data security breaches, including cyber attacks;
Pursuant to the subscriber’s agreement and for its services as attorney-in-fact, we earn a management fee calculated as a percentage of the direct and assumed premiums written by the Exchange.
estimated results for both Indemnity and the Exchange, and consideration of several factors for both entities including: their relative financial strength and capital position; projected revenue, expense and earnings for the subsequent year; future capital needs; as well as competitive position.
By virtue of its legal structure as a reciprocal insurer, the Exchange does not have the ability to enter into contractual relationships and therefore Indemnity serves as the attorney-in-fact on behalf of the Exchange for all claims handling services, investment management services, and certain other common overhead and service department functions in accordance with the subscriber’s agreement. The amounts Indemnity incurs on behalf of the Exchange in this capacity are reimbursed to Indemnity from the Exchange at cost. See Part II, Item 8. "Financial Statements and Supplementary Data - Note 13, Related Party, of Notes to Financial Statements" contained within this report.
Net revenue from operations increased 25.7% in 2016 as revenue growth outpaced the growth in expenses, and 4.3% in 2015. The two components of our primary revenue source, management fee revenue, are the management fee rate we charge, and the direct and assumed premiums written by the Exchange. The management fee rate was 25% for both 2016 and 2015. The direct and assumed premiums written by the Exchange were $6.3 billion in 2016 and $5.9 billion in 2015.
Total operating expenses increased 2.5% and 7.5% in 2016 and 2015, respectively. The increase in operating expenses for 2016 was driven by an increase in commissions, partially offset by lower non-commission expenses primarily from lower personnel costs across all expense categories. The increase in operating expenses for 2015 was driven primarily by increases in commissions and personnel costs.
Total investment income decreased in 2016 primarily due to lower earnings generated from limited partnership investments.
We disclose operating income, a non-GAAP financial measure, to enhance our investors’ understanding of our performance. Our method of calculating this measure may differ from those used by other companies, and therefore comparability may be limited.
We use operating income to evaluate the results of our operations. It reveals trends 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 which are not related to our ongoing operations. 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 prepared in accordance with U.S. generally accepted accounting principles ("GAAP") and does not reflect our overall profitability.
The following table reconciles net income and operating income for the years ended December 31:
Our portfolio of fixed maturity, equity security, and limited partnership investments is 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 the fair value of our investment portfolio and reported total investment income, which could have an adverse impact on our financial condition, results of operations, and cash flows.
We make estimates concerning the valuation of all investments. Valuation techniques are used to derive the fair value of the available-for-sale securities we hold. Fair value is the price that would be received to sell an asset in an orderly transaction between willing market participants at the measurement date.
short- and long-term prospects of the issuer and its industry based upon analysts’ recommendations;
While we perform various procedures in review of the general partners’ valuations, 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. Due to the limited market for these investments, there is higher 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. We analyze limited partnerships measured at fair value based upon NAV to determine if the most recently available NAV reflects fair value at the balance sheet date, with an adjustment being made where appropriate (change of plus or minus 5% compared to most recent NAV.)
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. Although we are the sponsor of these postretirement plans and record the funded status of these plans, the Exchange reimburses us for approximately 59% of the annual benefit expense of these plans, which represents pension benefits for our employees performing claims and life insurance functions and their share of service department costs.
Accumulated and projected benefit obligations are expressed as the present value of future cash payments. We discount those cash payments based upon a yield curve developed from corporate bond yield information with maturities that correspond to the payment of benefits. Lower discount rates increase present values and subsequent year pension expense, while higher discount rates decrease present values and subsequent year pension expense. The construction of the yield curve is based upon yields of corporate bonds rated AA or equivalent quality. Target yields are developed from bonds at various maturity points and a curve is fitted to those targets. Spot rates (zero coupon bond yields) are developed from 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. The cash flows from the yield curve were matched against our projected benefit payments in the pension plan, which have a duration of about 19 years. This yield curve supported the selection of a 4.24% discount rate for the projected benefit obligation at December 31, 2016 and for the 2017 pension expense. The same methodology was used to develop the 4.57% and 4.17% discount rates used to determine the projected benefit obligation for 2015 and 2014, respectively, and the pension expense for 2016 and 2015, 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 $3.8 million and would increase the pension benefit obligation by $37.0 million.
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 2016 or 2015.
Premiums generated from new business increased 4.3% to $753 million in 2016, compared to 3.9%, or $722 million, in 2015. Underlying the trend in new business premiums was a 0.9% increase in new business policies written in 2016, compared to
Commercial lines - Total commercial lines premiums written increased 5.4%, to $1.8 billion in 2016, compared to 2015, driven by a 2.3% increase in total commercial lines policies in force and a 3.1% increase in the total commercial lines year-over-year average premium per policy.
The management fee rate was set at 25%, the maximum rate, for 2016, 2015 and 2014. The management fee rate for 2017 was set at 25% by our Board of Directors. Changes in the management fee rate can affect our revenue and net income significantly. See also, the "Transactions/Agreements with Related Parties" section within this report.
Non-commission expense - Non-commission expense decreased $14.6 million in 2016 compared to 2015. Information technology costs decreased $2.1 million primarily due to decreased personnel costs somewhat offset by an increase in professional fees. Customer service costs decreased $4.7 million primarily due to decreased credit card processing fees and personnel costs. Administrative and other costs decreased $7.8 million due to decreased personnel costs, including incentive compensation forfeited by senior executives who separated from service during 2016, somewhat offset by an increase in professional fees. Personnel costs in all expense categories were impacted by decreased pension costs primarily due to an increase in the pension discount rate as well as decreased medical costs.
In 2015, compared to 2014, non-commission expense increased $23.8 million. Underwriting and policy processing costs increased $8.0 million due to increased personnel and postage costs. Information technology costs increased $2.3 million primarily due to hardware and software costs. Sales and advertising costs increased $4.1 million primarily due to personnel costs. Customer service costs increased $2.8 million due to an increase in personnel costs and credit card processing fees. Administrative and other costs increased $6.6 million due to personnel costs and professional fees. Personnel costs in all expense categories were impacted by increased pension and medical costs, and increased estimates for incentive plan compensation costs related to underwriting performance.
The gross margin in 2016 was 18.3%, compared to 15.4% in 2015 and 15.8% in 2014.
A summary of the results of our investment operations is as follows for the years ended December 31:
A breakdown of our net realized investment gains (losses) is as follows for the years ended December 31:
Net impairment losses recognized in earnings were $0.4 million in 2016, compared to $1.6 million in 2015, and $0.1 million in 2014. Net impairment losses recognized in earnings in both 2016 and 2015 were primarily due to securities in an unrealized loss position where we determined the loss was other-than-temporary based on credit factors, and also included securities in an unrealized loss position that we intended to sell prior to expected recovery to our cost basis.
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, 2016 reflect investment valuation changes resulting from the financial markets and the economy for the twelve month period ending September 30, 2016.
Equity in earnings of limited partnerships decreased by $10.0 million in 2016, compared to 2015, and increased by
$6.1 million in 2015, compared to 2014. The decrease in earnings in 2016 was the result of lower earnings from private equity investments that were partially offset by higher earnings from real estate investments. The increase in earnings in 2015 was due to higher earnings from private equity investments that were partially offset by lower earnings from real estate investments.
The financial statements of the Exchange are prepared in accordance with statutory accounting principles prescribed by the Commonwealth of Pennsylvania. Financial statements prepared under statutory accounting principles focus on the solvency of the insurer and generally provide a more conservative approach than under GAAP. Statutory direct written premiums of the Exchange and its wholly owned property and casualty subsidiaries grew 6.2% to $6.3 billion in 2016 from $5.9 billion in 2015. These premiums, along with investment income, are the major sources of cash that support the operations of the Exchange. Policyholders’ surplus, determined under statutory accounting principles, was $7.7 billion and $7.1 billion at December 31, 2016 and 2015, respectively. The Exchange and its wholly owned property and casualty subsidiaries' year-over-year policy retention ratio continues to be high at 89.8% at December 31, 2016 and 89.9% at December 31, 2015.
The following table presents a breakdown of the fair value of our fixed maturity portfolio by sector and rating as of December 31, 2016: (1)
(1) Ratings are supplied by S&P, Moody’s, and Fitch. The table is based upon the lowest rating for each security.
Equity securities classified as available-for-sale include certain exchange traded funds with underlying holdings of fixed maturity securities. These securities meet the criteria of a common stock under U.S. GAAP, and are included on the Statements of Financial Position as available-for-sale equity securities. These investments are carried at fair value of $5.9 million at December 31, 2016 and $12.7 million at December 31, 2015, with all changes in unrealized gains and losses reflected in other comprehensive income. The net unrealized loss on these securities, net of deferred taxes, was $0.1 million at December 31, 2016 and December 31, 2015.
In 2016, investments in limited partnerships decreased from the investment levels at December 31, 2015. Changes in partnership values are a function of contributions and distributions, adjusted for market value changes in the underlying investments. The decrease in limited partnership investments was due to net distributions received from the partnerships which were partially offset by increases in underlying asset values. We have made no new limited partnership commitments since 2006, and the balance of limited partnership investments is expected to decline over time as additional distributions are received. The results from our limited partnerships are based upon financial statements received from our general partners, which are generally received on a quarter lag. As a result, the market values and earnings recorded at December 31, 2016 reflect the partnership activity experienced during the twelve month period ending September 30, 2016.
The following table provides condensed cash flow information for the years ended December 31:
In 2016, we purchased 15,093 shares of our outstanding Class A nonvoting common stock outside of our publicly announced share repurchase program at a total cost of $1.5 million for the vesting of stock-based awards in conjunction with our long-term incentive plan, and for the rabbi trust outside director deferred compensation plan. These shares were delivered in 2016. In 2015, we purchased 111,535 shares of our outstanding Class A nonvoting common stock outside of our publicly announced share repurchase program at a total cost of $10.4 million for the vesting of stock-based awards in conjunction with our long-term incentive plan, for stock-based awards for executive management and an outside director, and for the rabbi trust outside director deferred compensation plan. These shares were delivered in 2015. In 2014, we purchased 64,398 shares of our outstanding Class A nonvoting common stock outside of our publicly announced share repurchase program at a total cost of $4.9 million for the vesting of stock-based awards for executive management and an outside director, and for awards under our long-term incentive plan. These shares were delivered in 2014.
1) cash and cash equivalents, which total approximately $189.1 million at December 31, 2016, 2) a $100 million bank revolving line of credit, and 3) liquidation of assets held in our investment portfolio, including common stock and investment grade bonds which totaled approximately $342.0 million at December 31, 2016. Volatility in the financial markets could impair our ability to sell certain of our fixed income securities or cause such securities to sell at deep discounts. Additionally, we have the ability to curtail or modify discretionary cash outlays such as those related to shareholder dividends and share repurchase activities.
We have certain obligations and commitments to make future payments under various contracts. As of December 31, 2016, the aggregate obligations were as follows:
The pension contribution for 2017 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. Any contributions required in future years will be an amount equal to the greater of the target normal cost for the plan year or the amount necessary to fund the plan to 100% plus interest to the date the contribution is made. 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, 2016 is $14.4 million. We expect to have sufficient cash flows from operations to meet the future benefit payments as these become due.
Operating leases - real estate are for 18 of our 25 field offices and two operating leases are for office space and a warehouse facility.
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. Given our defined tolerance for risk, risk model output is used to quantify the potential variability of future performance and the sufficiency of capital and liquidity levels.
We serve as attorney-in-fact for the policyholders at the Exchange, a reciprocal insurance exchange. Each applicant for insurance to a reciprocal insurance exchange signs a subscriber’s agreement that contains an appointment of an attorney-in-fact. Through the designation of attorney-in-fact, we are required to provide certain sales, underwriting, and policy issuance services to the policyholders of the Exchange, as discussed previously. Pursuant to the subscriber’s agreement, we earn a management fee for these services calculated as a percentage of the direct and assumed premiums written by the Exchange.
We make certain payments for claims and life insurance related costs, investment management services, common overhead expenses and certain service department costs incurred by us on behalf of the Exchange and its wholly owned subsidiaries. By virtue of its legal structure as a reciprocal insurer, the Exchange does not have the ability to enter into contractual relationships and therefore Indemnity serves as the attorney-in-fact on behalf of the Exchange for all claims handling services, investment management services, and certain other common overhead and service department functions in accordance with the subscriber’s agreement. These amounts are reimbursed to us based upon appropriate utilization statistics (employee count, square footage, vehicle count, project hours, etc.) in accordance with the subscriber's agreement and the service agreements between us and the Exchange’s wholly owned subsidiaries. All reimbursements are made on an actual cost basis and do not include a profit component. These reimbursements are settled on a monthly basis.
on behalf of the Exchange and EFL. We continually monitor the financial strength of the Exchange. The receivables from the Exchange for management fees and costs we pay on behalf of the Exchange and EFL are settled monthly.
(1) Net purchases of treasury stock in 2015 and 2016 includes the repurchase of our Class A common stock in the open market that were subsequently distributed to satisfy stock based compensation awards. See Note 11, "Capital Stock", for additional information on treasury stock transactions.
See accompanying notes to Financial Statements. See Note 16, "Supplementary Data on Cash Flows", for additional supplemental cash flow information.
The services we provide to the Exchange are related to the sales, underwriting and issuance of policies. The sales related services we provide include agent compensation and certain sales and advertising support services. Agent compensation includes scheduled commissions to agents based upon premiums written as well as additional commissions and bonuses to agents, which are earned by achieving targeted measures. Agent compensation comprised approximately 69% of our 2016 expenses. The underwriting services we provide include underwriting and policy processing and comprised approximately 10% of our 2016 expenses. The remaining services we provide include customer service and administrative support.
We also provide information technology services that support all the functions listed above that comprised approximately 9% of our 2016 expenses.
In February 2015, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2015-02, "Consolidation", which changed the analysis that a reporting entity must perform to determine whether it should consolidate certain types of legal entities. This guidance changed the conditions to be met in determining if a reporting entity has a variable
Indemnity adopted the new accounting standard on a retrospective basis effective with the annual reporting period ending December 31, 2015. The 2014 financial information within this report has been conformed to the presentation in accordance with the amended guidance. The effects on the financial statements of no longer consolidating the Exchange include:
Indemnity's management fee revenues are included on the face of the Statements of Operations. The Noncontrolling Interest - Exchange revenues and expenses are no longer included in the Statements of Operations, Statements of Comprehensive Income or Statements of Cash Flows.
There is no cumulative effect to Indemnity's shareholders’ equity. The noncontrolling interest in total equity that represented the amount of the Exchange’s subscribers’ equity was presented separately from Indemnity's shareholders’ equity.
In May 2015, the FASB issued ASU 2015-07, "Fair Value Measurement", which removes the requirement to categorize within the fair value hierarchy all investments for which fair value is measured using the net asset value per share practical expedient and limits the disclosure requirements. ASU 2015-07 is effective for annual and interim periods beginning after December 15, 2015 with early adoption permitted. Our disclosure was prepared in accordance with this amended guidance.
In November 2015, the FASB issued ASU 2015-17, "Balance Sheet Classification of Deferred Taxes". ASU 2015-17 simplifies the presentation of deferred income taxes by requiring deferred tax assets and liabilities to be classified as noncurrent in a classified statement of financial position. ASU 2015-17 is effective for annual periods beginning after December 15, 2016 with early adoption permitted. We adopted the guidance on a retrospective basis effective December 31, 2015. Prior to December 31, 2015, we were not required to present a classified balance sheet that distinguished between current and noncurrent deferred taxes.
In August 2016, the FASB issued ASU 2016-15, "Statement of Cash Flows", which provides guidance on how certain cash receipts and cash payments are presented and classified to reduce diversity in practice. ASU 2016-15 is effective for interim and annual reporting periods beginning after December 31, 2017. Early adoption is permitted, including adoption in an interim period. We do not expect the adoption of this guidance to have a material impact on our financial statements.
In June 2016, the FASB issued ASU 2016-13, "Financial Instruments-Credit Losses", which requires financial assets measured at amortized cost to be presented at the net amount expected to be collected through the use of a new forward-looking expected loss model and credit losses relating to available-for-sale debt securities to be recognized through an allowance for credit losses. ASU 2016-13 is effective for interim and annual reporting periods beginning after December 15, 2019. Early adoption for interim and annual periods beginning after December 15, 2018 is permitted. We are currently evaluating the potential impact of this guidance on our financial statements.
In February 2016, the FASB issued ASU 2016-02, "Leases", which requires lessees to recognize assets and liabilities arising from operating leases on the statement of financial position and to disclose key information about leasing arrangements. ASU 2016-02 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented
Available-for-sale securities - Fixed maturity, preferred stock, and common stock securities classified as available-for-sale are reported at fair value. Available-for-sale securities with a remaining maturity of 12 months or less are reported as current assets on the Statements of Financial Position. Unrealized holding gains and losses, net of related tax effects, on available-for-sale securities are recorded directly to shareholders’ equity as accumulated other comprehensive income (loss).
impairments that we did not intend to sell, the non-credit portion of the impairment would be recorded in other comprehensive income.
Trading securities - Common stock securities classified as trading securities are reported at fair value. Unrealized holding gains and losses on trading securities are included in net realized gains (losses) in the Statements of Operations. Realized gains and losses on sales of trading securities are recognized in income based upon the specific identification method. Dividend income is recognized as of the ex-dividend date.
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. Our ownership interest in partnerships accounted for under the equity method is generally less than 10%, and does not provide us the ability to significantly influence the operations of the partnerships. However, we believe the equity method most appropriately reflects the value of our economic interest in these investments. We also own certain real estate limited partnerships that do not meet the criteria of an investment company. These partnerships prepare 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 4, "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.
Fixed assets are stated at cost less accumulated depreciation and amortization. Fixed assets are primarily comprised of software, which includes internally used capitalized software and development costs, as well as equipment, buildings and building improvements, and leasehold improvements. Assets in use are depreciated using the straight-line method over the estimated useful life except for leasehold improvements, which are depreciated over the shorter of their economic useful life or the lease term. Software is depreciated over periods ranging from 3-7 years, equipment is depreciated over 3-10 years, and buildings and building improvements are depreciated over 20-45 years. We review long-lived assets for impairment whenever events or changes indicate that the carrying value may not be recoverable. Under these circumstances, if the fair value were less than the carrying amount of the asset, we would recognize a loss for the difference. We will capitalize applicable interest charges incurred during the construction period of long-term building projects as part of the historical cost of the asset.
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 upon proprietary models and are used when observable inputs are not available or in illiquid markets.
(1) Other investments measured at fair value represent real estate funds included on the balance sheet as limited partnership investments that are reported under the fair value option using the net asset value practical expedient. These amounts are not required to be categorized in the fair value hierarchy. The 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 the NAV represents fair value 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, 2016 and December 31, 2015. During the year ended December 31, 2016, no contributions were made and distributions totaling $0.9 million were received from these investments. During the year ended December 31, 2015, no contributions were made and distributions totaling $3.5 million were received from these investments. The amount of unfunded commitments related to the investments was $0.3 million as of December 31, 2016 and $0.6 million as of December 31, 2015.
(1) These amounts are reported in the Statements of Operations as net realized investment gains (losses) for the year ended December 31, 2015 on Level 3 securities.
The amortized cost and estimated fair value of fixed maturities at December 31, 2016, are shown below by remaining contractual term to maturity. Mortgage-backed securities are allocated based upon 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 are as follows. Data is provided by length of time for securities in a gross unrealized loss position.
The above securities 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.
Interest and dividend income are recognized as earned and recorded to net investment income. Investment income, net of expenses, was generated from the following portfolios for the years ended December 31:
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, 2016 are comprised of partnership financial results for the fourth quarter of 2015 and the first, second and third quarters of 2016. Given the lag in reporting, our limited partnership results do not reflect the market conditions of the fourth quarter of 2016. Cash contributions made to and distributions received from the partnerships are recorded in the period in which the transaction occurs.
The increase in software is primarily related to new electronic signature capabilities for our agents as well as new functionalities to integrate various systems to create a more streamlined process for our customers.
On November 11, 2016, we announced the construction of a new office building that will serve as part of our principal headquarters. The costs associated with this project are included in construction in progress. The project is expected to span approximately three years and is financed using a senior secured draw term loan credit facility. See Note 7, "Borrowing Arrangements".
For the years ended December 31, 2016, 2015 and 2014, depreciation and amortization of fixed assets totaled $15.1 million, $15.9 million and $15.7 million, respectively, and is included in all other operating expenses in the Statements of Operations.
As of December 31, 2016, we have access to a $100 million bank revolving line of credit with a $25 million letter of credit sublimit that expires on November 3, 2020. As of December 31, 2016, a total of $99.0 million remains available under the facility due to $1.0 million outstanding letters of credit, which reduces the availability for letters of credit to $24.0 million. We had no borrowings outstanding on our line of credit as of December 31, 2016. Bonds with a fair value of $110.3 million were pledged as collateral on the line at December 31, 2016. The securities pledged as collateral have no trading restrictions and are reported as available-for-sale securities in the Statements of Financial Position as of December 31, 2016. The banks require compliance with certain covenants, which include leverage ratios and debt restrictions, for our line of credit. We are in compliance with all covenants at December 31, 2016.
On November 7, 2016, we entered into a credit agreement for a $100 million senior secured draw term loan credit facility ("Credit Facility") for the acquisition of real property and construction of an office building that will serve as part of our principal headquarters. Under the agreement, $25 million will be drawn on December 1, 2016, June 1, 2017, December 1, 2017, and June 1, 2018 ("Draw Period"). During the Draw Period, we will make monthly interest only payments under the Credit Facility and thereafter the Credit Facility converts to a fully-amortized term loan with monthly payments of principal and interest over a period of 28 years. Borrowings under the Credit Facility will bear interest at a fixed rate of 4.35%. In addition, we are required to pay a quarterly commitment fee of 0.08% on the unused portion of the Credit Facility during the Draw Period. As of December 31, 2016, we have drawn $25 million against the facility. Bonds with a fair value of $108.2 million were pledged as collateral for the facility and are reported as available-for-sale securities in the Statements of Financial Position as of December 31, 2016. The bank requires compliance with certain covenants, which include leverage ratios, debt restrictions and minimum net worth, for our Credit Facility. We are in compliance with all covenants at December 31, 2016.
Amounts drawn from the Credit Facility are reported at carrying value on our Statements of Financial Position, net of unamortized loan origination and commitment fees. The estimated fair value of this borrowing at December 31, 2016 was $23.2 million. The estimated fair value was determined using estimates based upon interest rates and credit spreads and are classified as Level 3 in the fair value hierarchy as of December 31, 2016.
Although we are the sponsor of these postretirement plans and record the funded status of these plans, the Exchange reimburses us for approximately 59% of the annual benefit expense of these plans, which represents pension benefits for our employees performing claims and life insurance functions and their share of service department costs. For our funded pension plan, amounts are settled in cash for the portion of pension costs allocated to the Exchange. For our unfunded plans, we pay the obligations when due and amounts are settled in cash between entities when there is a payout.
Prior to 2003, the employee pension plan purchased annuities from Erie Family Life Insurance Company ("EFL"), a wholly owned subsidiary of the Exchange, for certain plan participants that were receiving benefit payments under the pension plan. These are nonparticipating annuity contracts under which EFL has unconditionally contracted to provide specified benefits to beneficiaries; however, the pension plan remains the primary obligor to the beneficiaries. A contingent liability of $21.0 million at December 31, 2016, exists in the event EFL does not honor the annuity contracts.
The rate of compensation increase for the employee plan is age-graded. An equivalent single compensation increase rate of 3.32% in 2016, 2015 and 2014 would produce similar results.
The economic assumptions that have the most impact on the postretirement benefits 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 2016 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 2015 and 2014.
assumption, we utilized models based upon rigorous historical analysis and forward-looking views of the financial markets based upon key factors such as historical returns for the asset class' applicable indices, the correlations of the asset classes under various market conditions and consensus views on future real economic growth and inflation. The expected future return for each asset class is then combined by considering correlations between asset classes and the volatilities of each asset class to produce a reasonable range of asset return results within which our expected long-term rate of return assumption falls.
Projected benefit obligations increased $92.1 million at December 31, 2016 compared to December 31, 2015. In addition to the normal increases in benefit accruals, the lower discount rate, partially offset by mortality tables being updated with two additional years of mortality data, contributed to this increase.
$19.0 million were made to the defined benefit pension plan in January 2017. The following table sets forth the funded status of the pension plans and the amounts recognized in the Statements of Financial Position at December 31:
Both the defined benefit pension plan and the SERP had accumulated benefit obligations in excess of plan assets at December 31, 2016 and 2015.
The estimated net actuarial loss and prior service cost for the pension plans that will be amortized from accumulated other comprehensive income into pension cost during 2017 is $9.3 million and $0.8 million, respectively.
All full-time and regular part-time employees are eligible to participate in a traditional qualified 401(k) or a Roth
At December 31, 2016, the plan awards for the 2014-2016 performance period were fully vested. Distributions will be made in 2017 once peer group financial information becomes available at which time participants will elect the form of payment, either cash or stock. The estimated plan award based upon the peer group information as of September 30, 2016 is $12.5 million. At December 31, 2015, the awards for the 2013-2015 performance period were fully vested. Participants had the option of receiving either cash or stock for the 2013-2015 award. The cash award of $12.6 million was paid in June 2016 and the stock award of 7,661 shares with an average share price of $96.64 and a market value of $0.7 million was delivered to plan participants in June 2016. At December 31, 2014, the awards, granted as stock, for the 2012-2014 performance period were fully vested. The cash award of $8.2 million was paid in June 2015 and the stock award of 1,567 shares with an average share price of $81.04 and a market value of $0.1 million was delivered to plan participants in June 2015.
Earned compensation costs are allocated to related entities and reimbursed to us in cash once the payout is made. The total compensation cost charged to operations related to these LTIP awards was $8.2 million in 2016, $13.4 million in 2015, and $12.5 million in 2014. The related tax benefits recognized in income were $2.9 million in 2016, $4.7 million in 2015, and $4.4 million in 2014. The Exchange reimburses us for approximately 44% of the annual compensation cost of these plans, which represents the amount of compensation expense for our employees performing claims and life insurance functions.
At December 31, 2016, there was $7.3 million of total unrecognized compensation cost for non-vested LTIP awards related to open performance periods. Unrecognized compensation is expected to be recognized over a period of two years.
Our equity compensation plan ("ECP") is designed to reward key employees, as determined by the ECDC or the chief executive officer, who can have a significant impact on our long-term performance and to further align the interests of such employees with those of our shareholders. The ECP permits grants of restricted shares, restricted share units and other share based awards, to be satisfied with shares of our Class A common stock or cash. The ECDC determines the form of the award to be granted at the beginning of each performance period. The number of shares of the Company's Class A common stock authorized for grant under the ECP is 100,000 shares, with no one person able to receive more than 5,000 shares in a calendar year. 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. The total number of restricted stock units granted under the plan was 4,500 in 2016, 5,500 in 2015, and 8,750 in 2014, respectively. The total compensation charged to operations related to these ECP awards was $0.8 million in 2016, $0.4 million in 2015, and $0.3 million in 2014, respectively. The Exchange reimburses us for approximately 30% of the annual compensation cost of these plans, which represents the amount compensation expense for our employees performing claims functions. Unrecognized compensation expense of $0.7 million is expected to be recognized over a period of three years.
In October 2015 we established a rabbi trust to hold the shares earned by outside directors. The rabbi trust purchased 7,432 shares of our common stock on the open market at an average price of $99.23 for $0.7 million in 2016, and 94,938 shares at an average price of $94.99 for $9.0 million in 2015. These shares were purchased to satisfy the liability of the deferred compensation plan. The rabbi trust is classified and accounted for as equity in a manner consistent with the accounting for treasury stock. Dividends received on the shares in the rabbi trust will be used to purchase additional shares. The shares will be distributed to the outside director from the rabbi trust upon ending board service.
(1) Forfeitures are the result of plan participants who separated from service with the Company in 2016 and 2015.
A management fee is charged to the Exchange for services we provide under subscriber’s agreements with policyholders at the Exchange. The fee is a percentage of direct and assumed premiums written by the Exchange. 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 2016, 2015 and 2014. The Board of Directors elected to maintain the fee at 25% beginning January 1, 2017.
All claims handling services for the Exchange are performed by our employees who are entirely dedicated to claims related activities. All costs associated with these employees, including postretirement benefits, are reimbursed to us from the Exchange’s revenues in accordance with the subscriber’s agreement. We are reimbursed by EFL from its revenues for all costs, including postretirement benefits, associated with employees who perform life insurance related operating activities for EFL in accordance with its service agreement with us. See also Note 8, "Postretirement Benefits" for a discussion of intercompany expense allocations under the postretirement benefit plans. Investment management services are also provided by Indemnity to the Exchange and EFL in accordance with the subscriber’s and services agreements, respectively. These services include Indemnity engaging third party investment management services for several assets classes on behalf of the Exchange. In addition, common overhead expenses and certain service department costs incurred by us on behalf of the Exchange and its wholly owed subsidiaries are reimbursed by the proper entity based upon appropriate utilization statistics (employee count, square footage, vehicle count, project hours, etc.) specifically measured to accomplish proportional allocations, which we believe are reasonable.
All reimbursements are made on an actual cost basis and do not include a profit component. We record these reimbursements as receivables from the Exchange and EFL with a corresponding reduction to our expenses. Reimbursements are settled on a monthly basis. The amounts incurred on behalf of the Exchange and EFL were as follows for the years ended December 31:
We are due $25 million from EFL in the form of a surplus note that was issued in 2003. The note may be repaid only out of unassigned surplus of EFL. Both principal and interest payments are subject to prior approval by the Pennsylvania Insurance
Commissioner. The note bears an annual interest rate of 6.7% 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 2016, 2015 and 2014.
We have contractual commitments to invest up to $16.9 million related to our limited partnership investments at December 31, 2016. These commitments are split between private equity securities of $6.8 million, mezzanine debt securities of $8.2 million, and real estate activities of $1.9 million. These commitments will be funded as required by the limited partnership agreements. In addition, we have commitments related to the remaining draws of the senior secured draw term loan credit facility. See Note 7, "Borrowing Arrangements".
A reconciliation of net income to net cash provided by operating activities as presented in the Statements of Cash Flows is as follows for the years ended December 31: