a 100% interest in the net earnings of EFL's life insurance operations;
Earnings on life insurance related invested assets are integral to the evaluation of the life insurance operations because of the long duration of life products. On that basis, for presentation purposes, the life insurance operations segment discussion includes the life insurance related investment results. However, also for presentation purposes, the segment footnote and the investment operations segment discussion include the life insurance investment results as part of the Exchange’s investment results.
DAC related to universal life products and deferred annuities is amortized over the estimated lives of the contracts in proportion to actual and expected future gross profits, which include investment, mortality, and expense margins and surrender charges. Both historical and anticipated investment returns, including realized gains and losses, are considered in determining the amortization of DAC. When the actual gross profits change from previously estimated gross profits, the cumulative DAC
amortization is re-estimated and adjusted by a cumulative charge or credit to current operations. When actual gross profits exceed those previously estimated, DAC amortization will increase, resulting in a current period charge to earnings. The opposite result occurs when the actual gross profits are below the previously estimated gross profits. DAC is also adjusted for the impact of unrealized gains or losses on investments as if these gains or losses had been realized, with corresponding credits or charges, net of income taxes, included in EFL’s accumulated other comprehensive income, which is presented in the “Noncontrolling interest in consolidated entity - Exchange,” amount in the Consolidated Statements of Financial Position.
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 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/
5.0% at December 31, 2013. The Property and Casualty Group’s year-over-year policy retention ratio was 90.3% at December 31, 2014, 90.6% at December 31, 2013, and 90.9% at December 31, 2012.
The 2014 direct business favorable development, including reserves for catastrophe losses and salvage and subrogation recoveries, totaled $120 million, improved the combined ratio by 2.3 points, and represented 3.2% of the net loss reserves at December 31, 2013. The most significant factors contributing to the 2014 favorable development were:
Indemnity generated net realized gains of $1 million in both 2014 and 2013, compared to gains of $5 million in 2012. The Exchange generated net realized gains of $192 million in 2014, compared to gains of $770 million in 2013 and $413 million in 2012. Realized gains for Indemnity were primarily attributable to gains from sales of equity securities in 2014, and gains from sales of fixed maturity securities in 2013. Indemnity recorded no changes in fair value of common stocks in 2014 or 2013 due to the sale of its common stock portfolio classified as trading securities in the fourth quarter of 2012. In 2012, Indemnity's net realized gains were primarily due to the favorable performance and sale of its common stock portfolio. Realized gains for the Exchange in 2014 primarily reflected gains from sales of common stock partially offset by decreases in fair value of common stock. Realized gains for the Exchange in 2013 and 2012 were primarily due to increases in fair value and realized gains on the sale of common stock securities reflecting favorable market performance.
Net cash provided by Indemnity’s operating activities decreased to $186 million in 2014, compared to $218 million in 2013, and $205 million in 2012. Decreased cash from operating activities in 2014 was primarily due to increases in commissions and bonuses paid to agents and general operating expenses combined with decreases in reimbursements collected from affiliates and limited partnership distributions. Somewhat offsetting this decrease in cash was an increase in management fee revenue received, compared to 2013. Management fee revenues were higher reflecting the increase in premiums written or assumed by the Exchange. Cash paid for agent commissions and bonuses increased to $749 million in 2014, compared to $681 million in 2013, as a result of an increase in cash paid for scheduled commissions and bonus awards. Indemnity contributed $23 million to its pension plan in 2014, compared to $17 million in 2013. Additionally, Indemnity made a contribution to its pension plan for $17 million in January 2015. Our funding policy 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% plus interest to the date the contribution is made. Indemnity is reimbursed approximately 56% of the net periodic benefit cost of the pension plan from its affiliates, which represents pension benefits for Indemnity employees performing claims and EFL functions. In 2013, increased cash from operating activities, compared to 2012, was primarily due to increases in management fee revenue and limited partnership distributions received. Offsetting this increase in cash were increases in cash paid for commissions to agents, general operating expenses, salaries and wages, and income taxes, combined with a slight decrease in net investment income received, compared to 2012.
Net cash used in Indemnity’s investing activities totaled $4 million in 2014 and $65 million in 2013, compared to cash provided of $95 million in 2012. Changes in Indemnity’s 2014 investing activities primarily included increased cash generated from fixed maturity and equity security sales, somewhat offset by decreased cash generated from fixed maturity calls combined with an increase in purchases of property, plant and equipment, compared to 2013. Also impacting Indemnity's future investing activities are limited partnership commitments, which totaled $24 million at December 31, 2014, and will be funded as required by the partnerships’ agreements. Of this amount, the total remaining commitment to fund limited partnerships that invest in private equity securities was $10 million, mezzanine debt securities was $9 million, and real estate activities was $5 million. Changes in Indemnity’s 2013 investing activities primarily included decreased cash generated from the sales of fixed maturities and common stocks, compared to 2012.
Outside of Indemnity’s normal operating and investing cash activities, future funding requirements could be met through:
The standard set by the National Association of Insurance Commissioners (NAIC) for measuring the solvency of insurance companies, referred to as Risk-Based Capital (RBC), is a method of measuring the minimum amount of capital appropriate for an insurance company to support its overall business operations in consideration of its size and risk profile. The RBC formula is used by state insurance regulators as an early warning tool to identify, for the purpose of initiating regulatory action, insurance companies that potentially are inadequately capitalized. In addition, the formula defines minimum capital standards that will supplement the current system of low fixed minimum capital and surplus requirements on a state-by-state basis. At December 31, 2014, the members of the Property and Casualty Group and EFL had RBC levels substantially in excess of levels that would require regulatory action.
The Exchange holds a surplus note for $20 million from EFL that is payable on demand on or after December 31, 2025; however, no principal or interest payments may be made without prior approval by the Pennsylvania Insurance Commissioner. Interest payments are scheduled to be paid semi-annually. The Exchange recognized interest income on the note of $1 million in both 2014 and 2013.
Unpaid losses and loss expenses include estimates for claims that have been reported and those that have been incurred but not reported, as well as estimates of all expenses associated with processing and settling these claims, less estimates of anticipated salvage and subrogation recoveries. Unpaid loss and loss expense reserves are set at ultimate cost, except for workers compensation loss reserves, which have been discounted using an interest rate of 2.5%. Estimating the ultimate cost of future losses and loss expenses is an uncertain and complex process. This estimation process is based upon the assumption that past developments are an appropriate indicator of future events, and involves a variety of actuarial techniques that analyze
Indemnity has not provided financial or other support to the Exchange for any of the reporting periods presented. At December 31, 2014, there are no explicit or implicit arrangements that would require Indemnity to provide future financial support to the Exchange. Indemnity is not liable if the Exchange was to be in violation of its debt covenants or was unable to meet its obligation for unfunded commitments to limited partnerships.
We review the fair value hierarchy classifications each reporting period. Transfers between hierarchy levels may occur due to changes in available market observable inputs. Transfers in and out of level classifications are reported as having occurred at the beginning of the quarter in which the transfers occurred.
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, 2014 are comprised of partnership financial results for the fourth quarter of 2013 and the first, second and third quarters of 2014. Given the lag in reporting, our limited partnership results do not reflect the market conditions of the fourth quarter of 2014. Cash contributions made to and distributions received from the partnerships are recorded in the period in which the transaction occurs.
Both lines have securities pledged as collateral that have no trading restrictions and are reported as available-for-sale fixed maturities in the Consolidated Statements of Financial Position as of December 31, 2014. The banks require compliance with certain covenants, which include leverage ratios for Indemnity’s line of credit and statutory surplus and risk based capital ratios for the Exchange’s line of credit. We are in compliance with all covenants at December 31, 2014.
Deferred policy acquisition costs asset, end of year - Erie Insurance Group
$25 million in excess of $1.1 billion. The property catastrophe reinsurance treaties that became effective for January 1, 2015 included a first property catastrophe reinsurance treaty providing coverage of up to 35% of a loss of $100 million in excess of the Property and Casualty Group’s loss retention of $300 million per occurrence, a second treaty providing coverage of up to 90% of a loss of $500 million in excess of $400 million, a third treaty providing coverage of up to 86% of a loss of
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 2014 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 2013 and 2012.
The target and actual asset allocations for the portfolio are as follows for the years ended December 31:
Non-U.S. equity securities - 11% are allocated to international small cap investments, while another 11% are allocated to international emerging market investments. The remaining 78% of the Non-U.S. equity securities are allocated to investments seeking to achieve excess returns relative to an international market index.
Our annual incentive plan is a bonus plan that pays cash to our executive and senior vice presidents annually. The cash awards are based on attainment of corporate and individual performance measures, which can include various financial measures. The plan includes a funding qualifier which considers Indemnity’s financial results, based on operating income, before a payout can be made to plan participants. If the funding qualifier is met, plan participants are eligible to receive the incentive based upon specific performance measures. The measures are established at the beginning of each year by the Executive Compensation and Development Committee of our Board of Directors (“ECDC”), with ultimate approval by the full Board of Directors. For 2014 and 2013, the performance measures primarily included the Property and Casualty Group’s direct written premium and statutory combined ratio.
Note receivable from EFL - Indemnity is 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, subject to prior approval by the Pennsylvania Insurance Commissioner. Indemnity recognized interest income on the note of $2 million in 2014 and 2013.