Indemnity and the Exchange also operate 25 field offices in 12 states to perform primarily claims-related activities. The Exchange owns seven field offices, Indemnity owns property, a portion of which houses one field office, and leases the remaining field offices from third parties. Commitments for properties leased from other parties expire periodically through 2027. We expect that most leases will be renewed or replaced upon expiration. Rental costs of shared facilities are allocated based upon usage or square footage occupied.
uncertainties, in addition to those set forth in our filings with the Securities and Exchange Commission, that could cause actual results and future events to differ from those set forth or contemplated in the forward-looking statements include the following:
•dependence upon our relationship with the Erie Insurance Exchange ("Exchange") and the management fee under the agreement with the subscribers at the Exchange;
•potential impacts of the COVID-19 pandemic on the growth and financial condition of the Exchange;
•costs of providing policy issuance and renewal services to the Exchange under the subscriber's agreement;
By virtue of its legal structure as a reciprocal insurer, the Exchange does not have any employees or officers. Therefore, it enters into contractual relationships by and through an attorney-in-fact. Indemnity serves as the attorney-in-fact on behalf of the Exchange with respect to its administrative services. The Exchange's insurance subsidiaries also utilize Indemnity for these services in accordance with the service agreements between each of the subsidiaries and Indemnity. Claims handling services include costs incurred in the claims process, including the adjustment, investigation, defense, recording and payment functions. Life insurance management services include costs incurred in the management and processing of life insurance business. Investment management services are related to investment trading activity, accounting and all other functions attributable to the investment of funds. Included in these expenses are allocations of costs for departments that support these administrative functions. The amounts incurred for these services are reimbursed to Indemnity at cost in accordance with the subscriber's agreement and the service agreements. State insurance regulations require that intercompany service agreements and any material amendments be approved in advance by the state insurance department.
Our results of operations are tied to the growth and financial condition of the Exchange as the Exchange is our sole customer, and our earnings are largely generated from management fees based on the direct and affiliated assumed premiums written by the Exchange. The Exchange generates revenue by insuring preferred and standard risks, with personal lines comprising 71% of the 2020 direct and affiliated assumed written premiums and commercial lines comprising the remaining 29%. The principal personal lines products are private passenger automobile and homeowners. The principal commercial lines products are commercial multi-peril, commercial automobile and workers compensation.
We generate investment income from our fixed maturity and equity security portfolios. Our portfolio is managed with the objective of maximizing after-tax returns on a risk-adjusted basis. We actively evaluate the portfolios for securities in an unrealized loss position and record impairment write-downs on investments in instances where we have the intent to sell or it's more likely than not that we would be required to sell the security. Impairments resulting from a credit loss are recognized in earnings with a corresponding allowance on the balance sheet.
(dollars in thousands, except per share data) 2020 % Change 2019 % Change 2018
Net income $ 293,304 (7.4) % $ 316,821 9.9 % $ 288,224
Management fee revenue for administrative services increased 4.0% to $59.5 million in 2020 compared to 6.7% to $57.2 million in 2019. The administrative services reimbursement revenue and corresponding cost of operations increased both total operating revenue and total operating expenses to $609.4 million in 2020 and $582.0 million in 2019, but had no net impact on operating income.
Total investment income decreased $7.1 million in 2020 primarily driven by higher impairments and lower net investment income reflecting lower interest rates due to market volatility caused by the COVID-19 pandemic. Total investment income increased $14.2 million in 2019 primarily driven by net realized investment gains and higher net investment income.
Income tax expense was $75.2 million in 2020 compared to $79.9 million in 2019. Income tax expense was reduced in 2019 by $4.0 million as a result of settling an uncertain tax position, which decreased our effective tax rate by 1.0%.
•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.
Level 3 securities are valued based upon unobservable inputs, reflecting our estimates of value based upon assumptions used by market participants. Securities are also assigned to Level 3 in cases where non-binding broker quotes are significant to the valuation and there is a lack of transparency as to whether these quotes are based upon information that is observable in the marketplace. Fair value estimates for securities valued using unobservable inputs require significant judgment due to the
As of each reporting period, financial instruments recorded at fair value are classified based upon the lowest level of input that is significant to the fair value measurement. The presence of at least one unobservable input that has significant impact to the fair value measurement 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.
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 2.96% discount rate for the projected benefit obligation at December 31, 2020 and for the 2021 pension expense. The same methodology was used to develop the 3.59% and 4.47% discount rates used to determine the projected benefit obligation for 2019 and 2018, respectively, and the pension expense for 2020 and 2019, 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 $6.8 million, of which our share would be approximately $2.8 million, and would increase the pension benefit obligation by $61.6 million.
The expected long-term rate of return for the pension plan represents the average rate of return to be earned on plan assets over the period the benefits included in the benefit obligation are to be paid. To determine the expected long-term rate of return 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. The expected long-term rate of return is less susceptible to annual revisions, as there are typically no significant changes in the asset mix. Based on the current asset allocation and a review of the key factors and expectations of future asset performance, we reduced the expected return on asset assumption from 6.00% to 5.50% for 2021. A change of 25 basis points in the expected long-term rate of return assumption, with other assumptions held constant, would have an estimated $2.3 million impact on net pension benefit cost in the following year, of which our share would be approximately $0.9 million.
We use a four-year averaging method to determine the market-related value of plan assets, which is used to determine the expected return component of pension expense. Under this methodology, asset gains or losses that result from returns that differ from our long-term rate of return assumption are recognized in the market-related value of assets on a level basis over a four-year period. The market-related asset experience during 2020 that related to the actual investment return being different from that assumed during the prior year was a gain of $146.3 million. Recognition of this gain will be deferred and recognized over a four-year period, consistent with the market-related asset value methodology. Once factored into the market-related asset value, these experience gains and losses will be amortized over a period of 14 years, which is the remaining service period of the employee group.
Estimates of fair values of the pension plan assets are obtained primarily from the trustee and custodian of our pension plan. Our Level 1 category includes a money market mutual fund and a separate account 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. Trustee and custodian valuation methodologies for Level 2 securities 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 2020 or 2019.
The actuarial assumptions we used in determining our pension obligation may differ materially from actual results due to changing market and economic conditions, higher or lower withdrawal rates, or longer or shorter life spans of participants. While we believe that the assumptions used are appropriate, differences in actual experience or changes in assumptions may materially affect our financial position, results of operations, or cash flows. See Item 8. "Financial Statements and Supplementary Data - Note 10, Postretirement Benefits, of Notes to Financial Statements" contained within this report for additional details on the pension plans.
We have two performance obligations in the subscriber’s agreement, providing policy issuance and renewal services and acting as attorney-in-fact for the Exchange, as well as the service provider for its insurance subsidiaries, with respect to all administrative services. We earn management fees for acting as the attorney-in-fact for the subscribers at the Exchange in these two capacities. Our revenues are allocated between the two performance obligations.
The management fee is calculated by multiplying all direct and affiliated assumed premiums written by the Exchange by the management fee rate, which is determined by our Board of Directors at least annually. The management fee rate was set at 25%, the maximum rate, for 2020, 2019 and 2018. Changes in the management fee rate can affect our revenue and net income significantly. The transaction price for management fee revenue and administrative service reimbursement revenue is allocated based on the estimated standalone selling prices developed using industry information and other available information for similar services. We update the transaction price allocation annually based upon the most recent information available or more frequently if there have been significant changes in any components considered in the transaction price. In 2020, we reviewed the transaction price allocation quarterly to consider the most current economic conditions related to the COVID-19 pandemic. The reviews resulted in no material change to the allocation.
Management fee revenue - policy issuance and renewal services, net $ 1,841,794 1.7 % $ 1,810,457 5.3 % $ 1,719,567
(2) Management fee revenue - administrative services is recognized over time as the services are performed. See Item 8. "Financial Statements - Note 3, Revenue, of Notes to Financial Statements" contained within this report.
Direct and affiliated assumed premiums include premiums written directly by the Exchange and premiums assumed from its wholly owned property and casualty subsidiaries. Direct and affiliated assumed premiums written by the Exchange increased 1.7% to $7.6 billion in 2020, from $7.5 billion in 2019, driven by an increase in policies in force. Year-over-year policies in force for all lines of business increased 2.1% in 2020 as the result of continuing strong policyholder retention, compared to 1.8% in 2019. The year-over-year average premium per policy for all lines of business decreased 0.4% at December 31, 2020, compared to an increase of 3.2% at December 31, 2019. The year-over-year average premium per policy at December 31, 2020 was impacted by the rate reductions for personal and commercial auto policies as a result of the COVID-19 pandemic.
Premiums generated from new business decreased 1.2% to $852 million in 2020. While new business policies written increased 5.0 % in 2020, year-over-year average premium per policy on new business decreased 5.9% at December 31, 2020, driven by the personal and commercial auto rate reductions which took effect in the third quarter of 2020. Premiums generated from new business decreased 2.6% to $863 million in 2019. While year-over-year average premium per policy on new business increased 5.1% at December 31, 2019, new business policies written decreased 7.4% in 2019.
Personal lines - Total personal lines premiums written increased 1.3% to $5.4 billion in 2020, from $5.3 billion in 2019, driven by an increase in total personal lines policies in force of 2.2%. While the impacts of the COVID-19 pandemic, including changes in consumer behavior and driving patterns, among others, significantly reduced new personal policies written in the second quarter of 2020, new personal policies written increased 20.7% in the second half of 2020, compared to the same period last year. Total personal lines year-over-year average premium per policy decreased 0.8% at December 31, 2020, compared to the prior year, driven by personal auto rate reductions. Total personal lines policies in force increased 1.8% in 2019 and year-over-year average premium per policy increased 2.9% at December 31, 2019.
Commercial lines - Total commercial lines premiums written increased 2.6% to $2.2 billion in 2020, compared to 2019, driven by a 1.6% increase in total commercial lines policies in force and a 0.9% increase in the total commercial lines year-over-year average premium per policy. While there was a significant reduction in new commercial policies written in the second quarter of 2020 as a result of the business disruptions and unfavorable economic conditions related to the COVID-19 pandemic, new commercial policies written increased 2.4% in the second half of 2020 compared to the same period last year. The second half of 2020 activity was primarily driven by an increase in commercial auto policies written which was partially offset by a decrease in workers compensation policies written. Total commercial lines premiums written increased 6.1% in 2019, compared to 2018, driven by a 2.4% increase in total commercial lines policies in force and a 3.6% increase in the total commercial lines year-over-year average premium per policy.
Future trends-premium revenue - Through a careful agency selection process, the Exchange plans to continue its effort to expand the size of its agency force to increase market penetration in existing operating territories to contribute to future growth. While our agents initially experienced business declines resulting from disruptions created by the COVID-19 pandemic, there have been no significant disruptions in their operations. The continued impacts of the COVID-19 pandemic could make it difficult for our independent agents to write new business and retain existing business and/or constrain our ability to recruit new agents.
Changes in premium levels attributable to rate changes also directly affect the profitability of the Exchange and have a direct bearing on our management fee. Pricing actions contemplated or taken by the Exchange are subject to various regulatory requirements of the states in which it operates. The pricing actions already implemented, or to be implemented, have an effect on the market competitiveness of the Exchange's insurance products. Such pricing actions, and those of the Exchange's competitors, could affect the ability of the Exchange's agents to retain and attract new business; additionally, exposure reductions and/or changes in mix of business as a result of economic conditions could impact the average premium written and affiliated assumed by the Exchange, as customers may reduce coverages.
The COVID-19 pandemic may have a negative impact on the Exchange's premiums, and therefore our management fees, given recessionary economic conditions and related declines in consumer activity and demand for certain services, as well as the potential for sustained changes in driving patterns. The remaining rate reductions implemented for personal and commercial auto policies in response to the COVID-19 pandemic are estimated to decrease premiums by $110 million with a corresponding decrease of $28 million in management fee revenue in 2021. Future premiums could also be impacted by potential regulatory changes resulting from the COVID-19 pandemic.
Service agreement revenue includes service charges we collect from subscribers/policyholders for providing extended payment terms on policies written and affiliated assumed by the Exchange, and late payment and policy reinstatement fees. The service charges are fixed dollar amounts per billed installment. The decrease in service agreement revenue reflects the continued shift to payment plans that do not incur service charges or offer a premium discount for certain payment methods.
Underwriting and policy processing $ 160,646 3.7 % $ 154,934 3.8 % $ 149,234
Commissions - Commissions increased $26.6 million in 2020 compared to 2019 resulting from higher direct and affiliated assumed premiums written by the Exchange and higher agent incentive compensation. The Exchange experienced a significant decrease in automobile claims frequency and related loss expense beginning in March 2020 that continued through May 2020 driven by the COVID-19 pandemic, which contributed to an increase in the profitability component of the agent incentive bonuses. Claims frequency increased in June 2020 and maintained consistent levels through the remainder of 2020. Commissions increased $40.9 million in 2019 compared to 2018 resulting from higher direct and affiliated assumed premiums written by the Exchange, somewhat offset by lower agent incentive costs related to less profitable growth.
We allocate a portion of the management fee, which currently equates to 0.8% of the direct and affiliated assumed premiums written by the Exchange, to the administrative services. This portion of the management fee is recognized as revenue over a four-year period representing the time over which the services are provided. We also report reimbursed costs as revenues, which are recognized monthly as services are provided.
By virtue of its legal structure as a reciprocal insurer, the Exchange does not have any employees or officers. Therefore, it enters into contractual relationships by and through an attorney-in-fact. Indemnity serves as the attorney-in-fact on behalf of the Exchange with respect to its administrative services in accordance with the subscriber's agreement. The Exchange's insurance subsidiaries also utilize Indemnity for these services in accordance with the service agreements between each of the subsidiaries and Indemnity. The amounts incurred for these services are reimbursed to Indemnity at cost in accordance with the subscriber's agreement and the service agreements. We record these reimbursements due from the Exchange and its insurance subsidiaries as a receivable.
Total investment income $ 32,867 (17.8) % $ 39,967 54.9 % $ 25,796
Serving in the capacity of attorney-in-fact for the Exchange, we are dependent on the growth and financial condition of the Exchange, who is our sole customer. The strength of the Exchange and its wholly owned subsidiaries is rated annually by A.M. Best Company through assessing its financial stability and ability to pay claims. The ratings are generally based upon factors relevant to policyholders and are not directed toward return to investors. The Exchange and each of its property and casualty subsidiaries are rated A+ "Superior", the second highest financial strength rating, which is assigned to companies that have achieved superior overall performance when compared to the standards established by A.M. Best and have a superior ability to meet obligations to policyholders over the long term. On July 8, 2020, the outlook for the financial strength rating was affirmed as stable. As of December 31, 2020, only approximately 12% of insurance groups, in which the Exchange is included, are rated A+ or higher.
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 U.S. generally accepted accounting principles. Statutory direct written premiums of the Exchange and its wholly owned property and casualty subsidiaries grew 1.7% to $7.6 billion in 2020 from $7.5 billion in 2019. 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 $10.7 billion and $9.5 billion at December 31, 2020 and 2019, respectively. The Exchange and its wholly owned property and casualty subsidiaries' year-over-year policy retention ratio continues to be high at 89.9% at December 31, 2020 and 90.0% at December 31, 2019.
We have prepared our financial statements considering the financial strength of the Exchange based on its A.M. Best rating and strong level of surplus. We are monitoring risks related to the COVID-19 pandemic on an ongoing basis and believe that the Exchange falls within established risk tolerances. However, see Part I, Item 1A. "Risk Factors" for possible outcomes that could impact that determination.
(1)The current portion of agent loans is included with prepaid expenses and other current assets in the Statements of Financial Position.
We continually review our investment portfolio for impairment and determine whether the impairment is a result of credit loss or other factors. We individually analyze all positions with an emphasis on those in a significant unrealized loss position. If we have the intent to sell or it's more likely than not that we would be required to sell the security before recovery of the amortized cost basis, the entire impairment is recognized in earnings. Factors considered in the evaluation of credit loss include the extent to which fair value is less than cost and fundamental factors specific to the issuer such as financial condition, changes in credit ratings, near and long-term business prospects and other factors, as well as the likelihood of recovery of the amortized cost of the security. Impairment resulting from credit loss is recognized in earnings with a corresponding allowance on the balance sheet. We believe our investment valuation philosophy and accounting practices result in appropriate and timely measurement of fair value and recognition of impairment.
Under our investment strategy, we maintain a fixed maturity portfolio that is of high quality and well diversified within each market sector. This investment strategy also achieves a balanced maturity schedule. Our fixed maturity portfolio is managed with the goal of achieving reasonable returns while limiting exposure to risk.
The following table presents a breakdown of the fair value of our fixed maturity portfolio by industry sector and rating as of December 31, 2020: (1)
Basic materials $ 0 $ 0 $ 3,277 $ 4,053 $ 8,911 $ 16,241
$ 146,270 $ 194,155 $ 161,983 $ 294,917 $ 130,911 $ 928,236
(2) Structured securities include residential and commercial mortgage-backed securities, collateralized debt obligations, and asset-backed securities.
The funded status of our postretirement benefit plans is recognized in the Statements of Financial Position, with a corresponding adjustment to accumulated other comprehensive income (loss), net of tax. At December 31, 2020, shareholders' equity amounts related to these postretirement plans increased by $20.0 million, net of tax, of which $10.6 million represents amortization of the prior service cost and net actuarial loss and $9.4 million represents the current period actuarial gain. The actuarial gain was driven by higher than expected returns on assets which exceeded losses incurred as a result of the lower discount rate in 2020. At December 31, 2019, shareholders' equity amounts related to these postretirement plans increased by $1.7 million, net of tax, of which $4.9 million represents amortization of the prior service cost and net actuarial loss offset by $3.2 million of current period actuarial loss. The 2019 actuarial loss was primarily due to the change in the discount rate assumption used to measure the future benefit obligations to 3.59% in 2019, from 4.47% in 2018. Although we are the sponsor of these postretirement plans and record the funded status of these plans, the Exchange and its subsidiaries reimburse us for approximately 59% of the annual benefit expense of these plans, which includes pension benefits for employees performing administrative services and their allocated share of costs for employees in departments that support the administrative functions.
In 2016, we entered into a credit agreement for a $100 million senior secured draw term loan credit facility ("Credit Facility") for the acquisition of real property and construction of an office building that will serve as part of our principal headquarters. On January 1, 2019, the Credit Facility converted to a fully-amortized term loan with monthly payments of principal and interest at a fixed rate of 4.35% over a period of 28 years. We capitalized applicable interest charges incurred during the construction period of long-term building projects as part of the historical cost of the asset. The building was completed in the fourth quarter of 2020.
Net cash provided by operating activities $ 342,595 $ 364,527 $ 263,585
Net (decrease) increase in cash $ (175,499) $ 70,322 $ 50,696
Net cash provided by operating activities was $342.6 million in 2020, compared to $364.5 million in 2019 and $263.6 million in 2018. Decreased cash provided by operating activities in 2020 was primarily due to an increase in cash paid for agent commissions of $33.3 million due to higher scheduled commissions driven by premium growth, increased general operating expenses paid of $17.4 million and increased administrative services expenses paid of $16.2 million. Offsetting the decrease in cash provided by operating activities was an increase of $42.5 million in management fee received driven by growth in direct and affiliated assumed premiums written by the Exchange, compared to 2019. Increased cash provided by operating activities in 2019 was primarily due to an increase of $93.8 million in management fee revenue received driven by growth in direct and affiliated assumed premiums written by the Exchange and a decrease in pension contributions and employee benefits paid of $72.8 million, driven by the $80 million accelerated pension contribution in 2018. Offsetting the increase in cash provided by operating activities was increased cash paid for agent commissions of $41.8 million due to higher scheduled commissions driven by premium growth, compared to 2018.
Net cash used in investing activities totaled $243.2 million in 2020, compared to $124.6 million in 2019 and $81.4 million in 2018. Net cash used in investing activities increased in 2020 as purchases of available-for-sale securities exceeded the proceeds generated from investment sales and maturities/calls of available-for-sale securities. Fixed asset purchases decreased $46.5 million in 2020 compared to 2019 primarily due to the completion of the new home office building in the fourth quarter of 2020 which was funded primarily by the senior secured draw term loan credit facility. In 2019, we generated more proceeds from investment activity, which were offset by higher purchases of available-for-sale securities and equity securities due to portfolio rebalancing. Fixed asset purchases also increased primarily related to the new home office building.
No shares of our Class A nonvoting common stock were repurchased in 2020, 2019 and 2018 in conjunction with our stock repurchase program. In 2011, our Board of Directors approved a continuation of the current stock repurchase program for a total of $150 million with no time limitation. This repurchase authority includes, and is not in addition to, any unspent amounts remaining under the prior authorization. We had approximately $17.8 million of repurchase authority remaining under this program at December 31, 2020, based upon trade date.
Outside of our normal operating and investing cash activities, future funding requirements could be met through: 1) cash and cash equivalents, which total approximately $161.2 million at December 31, 2020, 2) a $100 million bank revolving line of credit, and 3) liquidation of unpledged assets held in our investment portfolio, including preferred and common stock and investment grade bonds which totaled approximately $646.4 million at December 31, 2020. Volatility in the financial markets could impair our ability to sell certain 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, 2020, the aggregate obligations were as follows:
Net contractual obligations $ 460,155 $ 206,500 $ 102,361 $ 21,114 $ 130,180
(1) Long-term debt amount differs from the balance presented on the Statements of Financial Position as the amount in the table above includes interest and principal payments.
(4) Other commitments include various agreements for services, including information technology, support, and maintenance obligations, and other obligations in the ordinary course of business. These agreements are enforceable and legally binding and specify fixed or minimum quantities to be purchased and the approximate timing of the transaction. The table above also includes agreements that contain cancellation provisions, some of which may require us to pay a termination fee. The amounts under such contracts are included in the table above as we expect to make future cash payments according to the contract terms.
(5) The obligation for our unfunded Supplemental Employee Retirement Plan (SERP) for our executive and senior management is not included in gross contractual obligations. The accumulated benefit obligation for this plan at December 31, 2020 is $26.5 million. We expect to have sufficient cash flows from operations to meet the future benefit payments as these become due.
(6) We are reimbursed from the Exchange and its subsidiaries for a portion of the costs related to other commitments and operating leases.
Our funding policy for our defined benefit pension plan is generally to contribute 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%. Historically, this has resulted in an annual pension contribution. In 2018, however, we made accelerated pension contributions totaling $80 million. Following our 2018 contribution, we would not expect to make a subsequent contribution until the sum of the target normal costs for plan years beginning on and after December 31, 2017 exceeds $80 million, or earlier if a contribution is necessary to fund the plan to 100%.
The role of our Enterprise Risk Management ("ERM") function is to ensure that all significant risks are clearly identified, understood, proactively managed and consistently monitored to achieve strategic objectives for all stakeholders. Our ERM program views risk holistically across our entire group of companies. It ensures implementation of risk responses to mitigate potential impacts. See Part I, Item 1A. "Risk Factors" contained in this report for a list of risk factors.
Our Board of Directors has a broad oversight responsibility over our intercompany relationships with the Exchange. As a consequence, our Board of Directors may be required to make decisions or take actions that may not be solely in the interest of our shareholders, such as setting the management fee rate paid by the Exchange to us and ratifying any other significant activity.
We serve as attorney-in-fact for the subscribers 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 policy issuance and renewal services and act as the attorney-in-fact for the Exchange with respect to all administrative services, 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 affiliated assumed premiums written by the Exchange. By virtue of its legal structure as a reciprocal insurer, the Exchange does not have any employees or officers. Therefore, it enters into contractual relationships by and through the attorney-in-fact. The Exchange's insurance subsidiaries also utilize Indemnity for all administrative services in accordance with the service agreements between each of the subsidiaries and Indemnity. The amounts incurred for all administrative services are reimbursed to Indemnity at cost in accordance with the subscriber's agreement and the service agreements. These reimbursements are settled on a monthly basis. State insurance regulations require that intercompany service agreements and any material amendments be approved in advance by the state insurance department.
We lease the home office from the Exchange. Rent is based on rental rates of like property in Erie, Pennsylvania and all operating expenses including utilities, cleaning, repairs, real estate taxes, and property insurance are the responsibility of the tenant (Indemnity). Rental costs of shared facilities are allocated based upon usage or square footage occupied. We also had a lease commitment with EFL for a field office until 2018.
We have significant receivables from the Exchange and its affiliates that result in a concentration of credit risk. Net receivables from the Exchange and other affiliates were $494.6 million, or 23.4% of total assets, at December 31, 2020 and $468.6 million, or 23.2% of total assets, at December 31, 2019. These receivables include management fees due for policy issuance and renewal services performed by us under the subscriber's agreement, and certain costs we incur acting as the attorney-in-fact on behalf of the Exchange as well as the service provider for its insurance subsidiaries with respect to all administrative services,
We previously held a $25 million surplus note issued to us by EFL that was payable on demand on or after December 31, 2018. In 2018, EFL, with the appropriate approval from the Pennsylvania Insurance Commissioner, satisfied its obligation and repaid the surplus note. EFL paid related interest to us of $1.6 million in 2018.
Management fee revenue - policy issuance and renewal services, net $ 1,841,794 $ 1,810,457 $ 1,719,567
Class A common stock - basic $ 6.30 $ 6.80 $ 6.19
Class A common stock - diluted $ 5.61 $ 6.06 $ 5.51
Class A common stock Class B common stock Additional paid-in-capital Accumulated other comprehensive income (loss) Retained earnings Treasury stock Deferred compensation Total shareholders' equity
Balance, December 31, 2020 $ 1,992 $ 178 $ 16,487 $ (78,143) $ 2,393,624 $ (1,163,670) $ 17,580 $ 1,188,048
Net (decrease) increase in cash and cash equivalents (175,499) 70,322 50,696
Cash and cash equivalents, end of year $ 161,240 $ 336,739 $ 266,417
Transfer of investments from other investments to equity securities $ 13,041 $ 3,310 $ -
Liability incurred to purchase fixed assets $ 14,214 $ 6,800 $ 8,453
Operating lease assets obtained in exchange for new operating lease liabilities $ 4,943 $ 35,483 $ -
See accompanying notes to Financial Statements. See Note 18, "Supplementary Data on Cash Flows", for additional supplemental cash flow information.
Our results of operations are tied to the growth and financial condition of the Exchange. If any events occurred that impaired the Exchange’s ability to grow or sustain its financial condition, including but not limited to reduced financial strength ratings, disruption in the independent agency relationships, significant catastrophe losses, or products not meeting customer demands, the Exchange could find it more difficult to retain its existing business and attract new business. A decline in the business of the Exchange almost certainly would have as a consequence a decline in the total premiums paid and a correspondingly adverse effect on the amount of the management fees we receive. We also have an 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, "Concentrations of Credit Risk".
On March 11, 2020, the outbreak of the coronavirus ("COVID-19") was declared a global pandemic. The significant volatility in the financial markets, economic disruption and uncertainty resulting from the COVID-19 pandemic that began in the first quarter of 2020 continues to evolve and the pandemic’s ultimate impact and duration remain highly uncertain at this time. The Exchange’s previously announced rate reductions that became effective in the second half of 2020, coupled with the uncertain economic conditions, will likely continue to constrain the Exchange’s premium growth which will impact our management fee revenue. The Exchange’s underwriting profitability has improved largely due to declines in claims frequency. The extent and
We adopted ASC 606, "Revenue from Contracts with Customers" on January 1, 2018, using the modified retrospective method applied to all contracts. Under ASC 606, we determined that we have two performance obligations under the subscriber’s agreement. The first performance obligation is providing policy issuance and renewal services. The second performance obligation is acting as the attorney-in-fact on behalf of the Exchange, as well as the service provider for its insurance subsidiaries, with respect to all administrative services. Upon adoption of ASC 606, the management fee earned per the subscriber’s agreement, currently 25% of all direct and affiliated assumed premiums written by the Exchange, is allocated between the two performance obligations. Prior to the adoption of ASC 606, the entire management fee was allocated to the policy issuance and renewal services. Additionally, the expenses we incur and related reimbursements we receive related to the administrative services are presented gross in our Statement of Operations effective January 1, 2018.
Available-for-sale securities - Fixed maturity debt securities and redeemable preferred stock are classified as available-for-sale and reported at fair value with unrealized investment gains and losses, net of income taxes, recognized in other comprehensive income. Available-for-sale securities with a remaining maturity of 12 months or less and any security that we intend to sell as of the reporting date are classified as current assets.
Deferred tax assets and liabilities are recorded for temporary differences between the tax basis of assets and liabilities and the reported amounts in the financial statements, using the statutory tax rates in effect for the year in which the differences are expected to settle or be realized. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the results of operations in the period that includes the enactment date under the law. The need for valuation allowances on deferred tax assets are estimated based upon our assessment of the realizability of such amounts.
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 building and building improvements, equipment, furniture and fixtures, 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, buildings and building improvements are depreciated over 20-45 years, equipment is depreciated over 3-10 years, and furniture and fixtures are depreciated over 7 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 capitalize applicable interest charges incurred during the construction period of significant long-term building projects as part of the historical cost of the asset.
Other assets include operating lease assets, other investments, and other long-term prepaid assets. The determination of whether an arrangement is a lease and the related lease classification is made at inception of a contract. Our leases are classified as operating leases. Operating lease assets and liabilities are recorded at inception based on the present value of the future minimum lease payments over the lease term at commencement date. When an implicit rate for the lease is not available, we use our incremental borrowing rate based on the information available at commencement date to determine the present value of future payments. Lease terms include options to extend or terminate the lease when it is reasonably certain that we will exercise that option. Most of our lease contracts contain lease and non-lease components. Non-lease components are expensed as incurred. Operating lease assets are included in other assets, and the current and noncurrent portions of the operating lease liabilities are included in accounts payable and accrued expenses and other long-term liabilities, respectively.
Our more significant agent bonus plan is based upon an individual agency's property and casualty underwriting profitability and also includes a component for growth in agency property and casualty premiums if the agency's underwriting profitability targets for the book of business are met. The estimate for this agent bonus plan is based upon the performance over 36 months, and is modeled on a monthly basis using actual underwriting results for the two prior years and current year-to-date actual results and forecasted results for the remainder of the year. Our second agent bonus plan is based on an agency's one-year underwriting profitability and uses a similar model but considers actual and forecasted results for a calendar year only. At December 31 of each year, we use actual data available and record an accrual based upon the expected payment amount. These costs are included in cost of operations - policy issuance and renewal services.
Service agreement revenue consists of service charges we collect from policyholders for providing multiple payment plans on policies written by the Exchange and its property and casualty subsidiaries. Service charges, which are flat dollar charges for each installment billed beyond the first installment, are recognized as revenue when bills are rendered to the policyholder. Service agreement revenue also includes late payment and policy reinstatement fees, which are also recognized as revenue when bills are rendered to the policyholder.
Certain amounts previously reported in the 2019 and 2018 financial statements have been reclassified for comparative purposes to conform to the current period’s presentation. “Limited partnership investments” has now been combined within “Other assets” in the Statements of Financial Position and “Equity in earnings (losses) of limited partnerships” is now included in “Net investment income” in the Statements of Operations. The reclassifications had no effect on previously reported net income.
The first performance obligation is to provide policy issuance and renewal services that result in executed insurance policies between the Exchange or one of its insurance subsidiaries and the subscriber (policyholder). The subscriber (policyholder), receives economic benefits when substantially all the policy issuance or renewal services are complete and an insurance policy is issued or renewed by the Exchange or one of its insurance subsidiaries. It is at the time of policy issuance or renewal that the allocated portion of revenue is recognized.
The amount of management fee revenue we receive can vary due to the potential of mid-term cancellations. Management fees are returned to the Exchange when policyholders cancel their insurance coverage mid-term and unearned premiums are refunded to them. We maintain an estimated allowance to reduce the management fee to its estimated net realizable value to account for the potential of mid-term policy cancellations based on historical cancellation rates. In 2020, our historical cancellation rates were adjusted to include the potential for increased cancellations given the current economic conditions related to the COVID-19 pandemic. This estimated allowance has been allocated between the two performance obligations consistent with the revenue allocation proportions.
The following table disaggregates revenue by our two performance obligations for the years ended December 31:
Class A diluted earnings per share are calculated under the if-converted method, which reflects the conversion of Class B shares to Class A shares. Diluted earnings per share calculations include the dilutive effect of assumed issuance of stock-based awards under compensation plans that have the option to be paid in stock using the treasury stock method. See Note 11, "Incentive and Deferred Compensation Plans".
(dollars in thousands, except per share data) For the years ended December 31,
Allocated net income (numerator) Weighted shares (denominator) Per- share amount Allocated net income (numerator) Weighted shares (denominator) Per- share amount Allocated net income (numerator) Weighted shares (denominator) Per- share amount
$ 290,902 46,188,659 $ 6.30 $ 314,227 46,188,836 $ 6.80 $ 285,864 46,188,637 $ 6.19
$ 293,304 52,313,360 $ 5.61 $ 316,821 52,319,860 $ 6.06 $ 288,224 52,315,213 $ 5.51
$ 2,402 2,542 $ 945 $ 2,594 2,542 $ 1,020 $ 2,360 2,542 $ 928
Our available-for-sale and equity securities are recorded at fair value, which is the price that would be received to sell the asset in an orderly transaction between willing market participants as of the measurement date.
Although virtually all of our prices are obtained from third party sources, we also perform internal pricing reviews, including evaluating the methodology and inputs used to ensure that we determine the proper classification level of the financial instrument and reviewing securities with price changes that vary significantly from current market conditions or independent price sources. Price variances are investigated and corroborated by market data and transaction volumes. We have reviewed the pricing methodologies of our pricing service as well as other observable inputs and believe that the prices adequately consider market activity in determining fair value.
Corporate debt securities $ 566,425 $ 1,281 $ 559,319 $ 5,825
Corporate debt securities $ 454,880 $ 2,683 $ 443,873 $ 8,324
Total available-for-sale securities 11,645 (204) 712 19,995 (5,278) 61,613 (62,259) 26,224
Corporate debt securities $ 12,577 $ 10 $ 146 $ 2,020 $ (7,415) $ 11,542 $ (10,556) $ 8,324
Residential mortgage-backed securities 0 4 15 921 (32) 0 (908) 0
Commercial mortgage-backed securities 0 (9) (21) 478 (1,068) 7,281 (3,340) 3,321
Total Level 3 available-for-sale securities $ 12,577 $ 5 $ 141 $ 5,719 $ (8,515) $ 18,823 $ (17,105) $ 11,645
(1) These amounts are reported as net investment income and net realized investment gains (losses) for each of the periods presented above.
(in thousands) Amortized cost Gross unrealized gains Gross unrealized losses Estimated fair value
Corporate debt securities $ 546,096 $ 21,843 $ 1,514 $ 566,425
Corporate debt securities $ 450,295 $ 6,289 $ 1,704 $ 454,880
The amortized cost and estimated fair value of available-for-sale securities at December 31, 2020, are shown below by remaining contractual term to maturity. 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.
The below securities have been evaluated and determined to be temporary declines in fair value for which we expect to recover our entire principal plus interest. The following tables present available-for-sale securities based on length of time in a gross unrealized loss position as of:
Corporate debt securities $ 25,804 $ 342 $ 15,699 $ 1,362 $ 41,503 $ 1,704 158
As of December 31, 2020, the current expected credit loss allowance on agent loans is $1.1 million and the credit loss allowance on available-for-sale securities is $0.2 million.
Investment income, net of expenses, was generated from the following portfolios for the years ended December 31:
Investment income, net of expenses $ 29,753 $ 34,059 $ 29,387
Net realized investment gains (losses) $ 6,392 $ 6,103 $ (2,010)
Less: net (losses) gains recognized on securities sold (469) 360 (86)
Net unrealized gains (losses) recognized on securities held at reporting date $ 5,525 $ 1,124 $ (733)
Impairments on available-for-sale securities and agent loans were as follows for the years ended December 31:
Net impairment losses recognized in earnings $ 3,278 $ 195 $ 1,581
The following table summarizes our fixed assets by category as of December 31:
We currently have leases for real estate, technology equipment, copiers, and vehicles. Our largest operating lease asset at December 31, 2020 of $6.3 million is for office space leased from the Exchange, including the home office. Under this lease, rent is based on rental rates of like property and all operating expenses are the responsibility of the tenant (Indemnity). The lease agreement expires December 31, 2021. See Note 15, "Related Party".
Operating lease costs for the years ended December 31, 2020 and 2019 totaled $13.1 million and $14.0 million, respectively. Of this amount, the Exchange and its subsidiaries reimbursed us $5.3 million and $6.0 million for the years ended December 31, 2020 and 2019, respectively, which represents the allocated share of lease costs supporting administrative services activities.
As of December 31, 2020, we have access to a $100 million bank revolving line of credit with a $25 million letter of credit sublimit that expires on October 30, 2023. As of December 31, 2020, a total of $99.1 million remains available under the facility due to $0.9 million outstanding letters of credit, which reduces the availability for letters of credit to $24.1 million. We had no borrowings outstanding on our line of credit as of December 31, 2020. Investments with a fair value of $124.9 million were pledged as collateral on the line at December 31, 2020. The securities pledged as collateral have no trading restrictions and are reported as available-for-sale securities and cash and cash equivalents as of December 31, 2020. 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, 2020.
Although we are the sponsor of these postretirement plans and record the funded status of these plans, the Exchange and its subsidiaries reimburse us for approximately 59% of the annual benefit expense of these plans, which represents pension benefits for employees performing administrative services and their allocated share of costs for employees in departments that support the administrative functions. For our funded pension plan, amounts are settled in cash for the portion of pension costs allocated to the Exchange and its subsidiaries. For our unfunded plans, we pay the obligations when due and amounts are settled in cash between entities when there is a payout.
(1) Pension plan costs represent the total cost before reimbursements to Indemnity from the Exchange and its subsidiaries.
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 all periods presented was based upon a yield curve developed from corporate bond yield information.
Both the defined benefit plan and the SERP had projected benefit obligations in excess of plan assets at December 31:
Fair value of plan assets, end of year $ 1,081,061 $ 907,625
The employee pension plan utilizes a return seeking and a liability asset matching allocation strategy. It is based upon the understanding that 1) equity investments are expected to outperform debt investments over the long-term, 2) the potential volatility of short-term returns from equities is acceptable in exchange for the larger expected long-term returns, and 3) a portfolio structured across investment styles and markets (both domestic and foreign) reduces volatility. As a result, the employee pension plan's investment portfolio utilizes a broadly diversified asset allocation across domestic and foreign equity and debt markets. The investment portfolio is composed of commingled pools and a separate account that are dedicated exclusively to the management of employee benefit plan assets.
(2) Non-U.S. equity securities - 11% are allocated to international small cap investments, while another 21% are allocated to international emerging market investments. The remaining 68% of the Non-U.S. equity securities are allocated to investments seeking to achieve excess returns relative to an international market index.
(3) Debt securities - 33% are allocated to long U.S. Treasury Strips, 67% are allocated to U.S. corporate bonds with an emphasis on long duration bonds rated A or better.
U.S. equity securities $ 248,585 $ 0 $ 248,585 $ 0
Estimates of fair values of the pension plan assets are obtained primarily from the trustee and custodian of our pension plan. Our Level 1 category includes a money market mutual fund and a separate account 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. Trustee and custodian valuation methodologies for Level 2 securities 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.
Our annual incentive plan ("AIP") is a bonus plan that pays cash to our executives, senior vice presidents and other selected officers annually. Participants can elect to defer up to 100% of the award under either the deferred compensation plan or the incentive compensation deferral plan. If the funding qualifier is met, plan participants are eligible to receive the incentive based upon attainment of corporate and individual performance measures, which can include various financial measures. The measures are established at the beginning of each year by the Executive Compensation and Development Committee of our Board of Directors ("ECDC"), with ultimate approval by the full Board of Directors. The corporate performance measures included the growth in direct written premium and statutory combined ratio of the Exchange and its property and casualty subsidiaries for all periods presented.
Our long-term incentive plan ("LTIP") is a performance based incentive plan designed to reward executives, senior vice presidents and other selected officers who can have a significant impact on our long-term performance and to further align the interests of such employees with those of our shareholders. The LTIP permits grants of performance shares or units, or phantom shares to be satisfied with shares of our Class A common stock or cash payment as determined by the ECDC. Participants can elect to defer up to 100% of the award under the incentive compensation deferral plan. The ECDC determines the form of the award to be granted at the beginning of each performance period, which is generally a three-year period. The number of shares of the Company's common stock authorized for grant under the LTIP is 1.5 million shares, with no one person able to receive more than 250,000 shares or the equivalent of $5 million during any one performance period. We repurchase our Class A common stock on the open market to settle stock awards under the plan. We do not issue new shares of common stock to settle stock awards. LTIP awards are considered vested at the end of each applicable performance period.
The LTIP provides the recipient the right to earn performance shares or units, or phantom stock based on the level of achievement of performance goals as defined by us. Performance measures and a peer group of property and casualty companies to be used for comparison are determined by the ECDC. The performance measures for all periods presented were the reported growth in direct written premium and statutory combined ratio of the Exchange and its property and casualty subsidiaries and return on invested assets over a three-year performance period as compared to the results of the peer group over the same period. Because the award is based upon a comparison to results of a peer group over a three-year period, the award accrual is based upon estimates of probable results for the remaining performance period. This estimate is subject to variability if our results or the results of the peer group are substantially different than the results we project.
The rabbi trust purchased 7,401 shares of our common stock on the open market at an average price of $201.78 for $1.5 million in 2020, 7,370 shares at an average price of $194.62 for $1.4 million in 2019, and 9,285 shares at an average price of $122.19 for $1.1 million in 2018 to satisfy the liability of the stock compensation plan for outside directors. The shares are distributed to the outside director from the rabbi trust upon ending board service. The total compensation charged to operations related to these awards totaled $0.9 million, $1.1 million and $0.8 million in 2020, 2019 and 2018, respectively.
Funding of rabbi trust for incentive compensation deferral plan (3,972) (774) (1,401)
Income tax at statutory rate $ 77,388 $ 83,308 $ 77,977
Temporary differences and carry-forwards, which give rise to deferred tax assets and liabilities, are as follows as of December 31:
If we determine that any of our deferred tax assets will not result in future tax benefits, a valuation allowance must be established for the portion of the assets that are not expected to be realized. We had no valuation allowance recorded at December 31, 2020 or 2019.
Balance at the end of the year $ 0 $ 0 $ 3,088
Before Tax Income Tax Net Before Tax Income Tax Net Before Tax Income Tax Net
OCI (loss) 23,720 4,982 18,738 14,833 3,115 11,718 (12,579) (2,642) (9,937)
Investment securities 23,720 4,982 18,738 14,833 3,115 11,718 (12,579) (2,642) (9,937)
Pension and other postretirement plans 25,300 5,313 19,987 2,149 451 1,698 45,205 9,493 35,712
We lease the home office from the Exchange. See Note 8, "Leases". Lease expense totaled $6.1 million in both 2020 and 2019 and $6.0 million in 2018. Operating expenses, including utilities, cleaning, repairs, real estate taxes, and property insurance, totaled $15.7 million, $16.7 million, and $13.5 million in 2020, 2019, and 2018, respectively. The Exchange and its subsidiaries reimburse us for rent costs and related operating expenses of shared facilities used to perform administrative services, which are allocated based upon usage or square footage occupied. Reimbursements related to the use of this space totaled $4.6 million, $4.2 million, and $3.9 million in 2020, 2019, and 2018, respectively. We also had a lease commitment with EFL for a field office until 2018. Annual rentals paid to EFL under this lease totaled $0.4 million in 2018.
In 2020, we entered into an agreement with a bank for the establishment of a loan participation program for agent loans. The maximum amount of loans to be funded through this program is $100 million. We have committed to fund a minimum of 30% of each loan executed through this program. As of December 31, 2020, the total loans executed under this agreement totaled $14.9 million, of which our portion of the loans is $6.4 million. Additionally, we have agreed to guarantee a portion of the funding provided by the other participants in the program in the event of default. As of December 31, 2020, our maximum potential amount of future payments on the guaranteed portion is $1.5 million. All loan payments under the participation program are current as of December 31, 2020.
We are involved in litigation arising in the ordinary course of conducting business. In accordance with current accounting standards for loss contingencies and based upon information currently known to us, we establish reserves for litigation when it is probable that a loss associated with a claim or proceeding has been incurred and the amount of the loss or range of loss can be reasonably estimated. When no amount within the range of loss is a better estimate than any other amount, we accrue the minimum amount of the estimable loss. To the extent that such litigation against us may have an exposure to a loss in excess of the amount we have accrued, we believe that such excess would not be material to our financial condition, results of operations, or cash flows. Legal fees are expensed as incurred. We believe that our accruals for legal proceedings are appropriate and, individually and in the aggregate, are not expected to be material to our financial condition, results of operations, or cash flows.