Fair Value

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. There are three levels of inputs that may be used to measure fair values:

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

The Company used the following methods and significant assumptions to estimate the fair value of each type of financial instrument:

Investment Securities: The fair values for investment securities are determined by quoted market prices, if available (Level 1). For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2). For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3). Level 3 pricing is obtained from a third-party based upon similar trades that are not traded frequently without adjustment by the Company. At March 31, 2017, the Company held $6.8 million in Level 3 securities which consist of $6.4 million of non-rated Obligations of State and Political Subdivisions and $353 thousand of equity securities that are not actively traded. Absent the credit rating, significant assumptions must be made such that the credit risk input becomes an unobservable input and thus these securities are reported by the Company in a Level 3 classification.

Derivatives: The fair values of derivatives are based on valuation models using observable market data as of the measurement date (Level 2).

Impaired Loans: Fair values for impaired collateral dependent loans are generally based on appraisals obtained from licensed real estate appraisers and in certain circumstances consideration of offers obtained to purchase properties prior to foreclosure. Appraisals for commercial real estate generally use three methods to derive value: cost, sales or market comparison and income approach. The cost method bases value in the cost to replace the current property. Value of market comparison approach evaluates the sales price of similar properties in the same market area. The income approach considers net operating income generated by the property and an investor's required return. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Comparable sales adjustments are based on known sales prices of similar type and similar use properties and duration of time that the property has been on the market to sell. Such adjustments made in the appraisal process are typically significant and result in a Level 3 classification of the inputs for determining fair value.

Appraisals for both collateral-dependent impaired loans and other real estate owned are performed by certified general appraisers (for commercial properties) or certified residential appraisers (for residential properties) whose qualifications and licenses have been reviewed and verified by the Company. Once received, a member of the Company’s Risk Management Area reviews the assumptions and approaches utilized in the appraisal. In determining the value of impaired collateral dependent loans and other real estate owned, significant unobservable inputs may be used which include: physical condition of comparable properties sold, net operating income generated by the property and investor rates of return.

Other Real Estate: Nonrecurring adjustments to certain commercial and residential real estate properties classified as other real estate (ORE) are measured at the lower of carrying amount or fair value, less costs to sell. Fair values are generally based on third party appraisals of the property utilizing similar techniques as discussed above for Impaired Loans, resulting in a Level 3 classification. In cases where the carrying amount exceeds the fair value, less costs to sell, impairment loss is recognized.

Loan Servicing Rights: On a quarterly basis, loan servicing rights are evaluated for impairment based upon the fair value of the rights as compared to carrying amount resulting in a Level 2 classification. The valuation model utilizes interest rate, prepayment speed, and default rate assumptions that market participants would use in estimating future net servicing income and that can be validated against available market data.

Loans Held-for-Sale: The fair values of loans held for sale are determined by using quoted prices for similar assets, adjusted for specific attributes of that loan resulting in a Level 2 classification.

Assets and Liabilities Measured on a Recurring Basis

Assets and liabilities measured at fair value on a recurring basis, including financial assets and liabilities for which the Company has elected the fair value option, are summarized below:



	Fair Value Measurements at March 31, 2017 Using
	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Assets:
Obligations of State and Political Subdivisions	$	—	$	250,896	$	6,447	$	257,343
MBS/CMO - Residential	—		468,656		—		468,656
Equity Securities	—		—		353		353
Total Securities	$	—	$	719,552	$	6,800	$	726,352

Loans Held-for-Sale	$	—	$	6,856	$	—	$	6,856

Derivative Assets	$	—	$	1,548	$	—	$	1,548

Mortgage Servicing Rights	$	—	$	593	$	—	$	593

Derivative Liabilities	$	—	$	1,579	$	—	$	1,579



	Fair Value Measurements at December 31, 2016 Using
	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Assets:
Obligations of State and Political Subdivisions	$	—	$	240,224	$	7,295	$	247,519
MBS/CMO - Residential	—		461,914		—		461,914
Equity Securities	—		—		353		353
Total Securities	$	—	$	702,138	$	7,648	$	709,786

Loans Held-for-Sale	$	—	$	15,273	$	—	$	15,273

Derivative Assets	$	—	$	1,291	$	—	$	1,291

Mortgage Servicing Rights	$	—	$	611	$	—	$	611

Derivative Liabilities	$	—	$	1,238	$	—	$	1,238

There were no transfers between Level 1 and Level 2 for the periods ended March 31, 2017 and December 31, 2016.

At March 31, 2017, the aggregate fair value of the Loans Held-for-Sale was $6,856. Aggregate contractual principal balance was $6,697 with a difference of $159. At December 31, 2016, the aggregate fair value of the Loans Held-for-Sale was $15,273. Aggregate contractual principal balance was $14,983 with a difference of $290.

The table below presents a reconciliation of all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three months ended March 31, 2017 and 2016:



	Obligations of State and Political Subdivisions						Equity Securities
	2017			2016			2017		2016

Balance of Recurring Level 3 Assets at January 1	$	7,295		$	9,020		$	353	$	353
Total Gains or Losses (realized/unrealized) Included in Other Comprehensive Income	17			121			—		—
Maturities / Calls	(865		)	(845		)	—		—
Purchases	—			—			—		—
Balance of Recurring Level 3 Assets at March 31	$	6,447		$	8,296		$	353	$	353

Of the total gain/loss included in earnings for the three months ended March 31, 2017, $17 was attributable to other changes in fair value. Of the total gain/loss included in earnings for the three months ended March 31, 2016, $121 was attributable to other changes in fair value. The three months ended March 31, 2017 and 2016 included no gain/loss attributable to interest income on securities.

Assets and Liabilities Measured on a Non-Recurring Basis

Assets and liabilities measured at fair value on a non-recurring basis are summarized below:



	Fair Value Measurements at March 31, 2017 Using
	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Assets:
Impaired Loans
Commercial and Industrial Loans	$	—	$	—	$	57	$	57
Commercial Real Estate Loans	—		—		1,395		1,395



	Fair Value Measurements at December 31, 2016 Using
	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Assets:
Impaired Loans
Commercial and Industrial Loans	$	—	$	—	$	60	$	60
Commercial Real Estate Loans	—		—		348		348

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a carrying amount of $1,985 with a valuation allowance of $533, resulting in an increase to the provision for loan losses of $278 for the period ended March 31, 2017. For the three months ended March 31, 2016, impaired loans resulted in a reduction to the provision for loan losses of $5. Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a carrying amount of $663 with a valuation allowance of $255, resulting in an increase to the provision for loan losses of $115 for the year ended December 31, 2016.

There was no Other Real Estate carried at fair value less costs to sell at March 31, 2017. No charge to earnings was included in the three months ended March 31, 2017 and 2016. There was no Other Real Estate carried at fair value less costs to sell at December 31, 2016. A charge to earnings through Other Operating Income of $75 was included in the year ended December 31, 2016.

The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at March 31, 2017 and December 31, 2016:



March 31, 2017	Fair Value		Valuation Technique(s)	Unobservable Input(s)	Range (Weighted Average)

Impaired Loans - Commercial and Industrial Loans	$	57	Sales comparison approach	Adjustment for physical condition of comparable properties sold	0%-100% (89%)
Impaired Loans - Commercial Real Estate Loans	$	1,395	Sales comparison approach	Adjustment for physical condition of comparable properties sold	30%-76% (64%)



December 31, 2016	Fair Value		Valuation Technique(s)	Unobservable Input(s)	Range (Weighted Average)

Impaired Loans - Commercial and Industrial Loans	$	60	Sales comparison approach	Adjustment for physical condition of comparable properties sold	0%-100% (89%)
Impaired Loans - Commercial Real Estate Loans	$	348	Sales comparison approach	Adjustment for physical condition of comparable properties sold	33%-77% (56%)

The carrying amounts and estimated fair values of the Company’s financial instruments not previously presented are provided in the tables below for the periods ending March 31, 2017 and December 31, 2016. Not all of the Company’s assets and liabilities are considered financial instruments, and therefore are not included in the tables. Because no active market exists for a significant portion of the Company’s financial instruments, fair value estimates were based on subjective judgments, and therefore cannot be determined with precision.



				Fair Value Measurements at March 31, 2017 Using
	Carrying Value			Level 1			Level 2			Level 3			Total
Financial Assets:
Cash and Short-term Investments	$	37,439		$	30,151		$	7,288		$	—		$	37,439
Securities Held-to-Maturity	—			—			—			—			—
Loans, Net	1,966,954			—			—			1,968,693			1,968,693
FHLB Stock and Other Restricted Stock	13,048			N/A			N/A			N/A			N/A
Accrued Interest Receivable	11,816			—			3,660			8,156			11,816
Financial Liabilities:
Demand, Savings, and Money Market Deposits	(1,962,637		)	(1,962,637		)	—			—			(1,962,637		)
Time Deposits	(363,835		)	—			(362,964		)	—			(362,964		)
Short-term Borrowings	(96,569		)	—			(96,569		)	—			(96,569		)
Long-term Debt	(144,789		)	—			(133,465		)	(10,859		)	(144,324		)
Accrued Interest Payable	(736		)	—			(722		)	(14		)	(736		)



				Fair Value Measurements at December 31, 2016 Using
	Carrying Value			Level 1			Level 2			Level 3			Total
Financial Assets:
Cash and Short-term Investments	$	64,816		$	48,467		$	16,349		$	—		$	64,816
Securities Held-to-Maturity	—			—			—			—			—
Loans, Net	1,974,074			—			—			1,980,523			1,980,523
FHLB Stock and Other Restricted Stock	13,048			N/A			N/A			N/A			N/A
Accrued Interest Receivable	11,413			—			3,289			8,124			11,413
Financial Liabilities:
Demand, Savings, and Money Market Deposits	(1,971,370		)	(1,971,370		)	—			—			(1,971,370		)
Time Deposits	(378,181		)	—			(378,000		)	—			(378,000		)
Short-term Borrowings	(137,554		)	—			(137,554		)	—			(137,554		)
Long-term Debt	(120,560		)	—			(109,709		)	(10,793		)	(120,502		)
Accrued Interest Payable	(789		)	—			(775		)	(14		)	(789		)

Cash and Short-term Investments:

The carrying amount of cash and short-term investments approximate fair values and are classified as Level 1 or Level 2.

Securities Held-to-Maturity:

The fair values for investment securities are determined by quoted market prices, if available (Level 1). For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2).

FHLB Stock and Other Restricted Stock:

It is not practical to determine the fair values of FHLB stock and other restricted stock due to restrictions placed on their transferability.

Loans:

Fair values of loans, excluding loans held for sale and collateral dependent impaired loans carried at fair value, are estimated as follows: For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values resulting in a Level 3 classification. Fair values for other loans are estimated using discounted cash flow analysis, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification. Impaired loans are valued as described previously. The methods utilized to estimate fair value of loans do not necessarily represent an exit price.

Accrued Interest Receivable:

The carrying amount of accrued interest approximates fair value resulting in a Level 2 or Level 3 classification consistent with the asset they are associated with.

Deposits:

The fair values disclosed for demand deposits (e.g., interest and non-interest checking, savings and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amount) resulting in a Level 1 classification. Fair values for fixed rate time deposits are estimated using a discounted cash flows calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits resulting in a Level 2 classification.

Short-term Borrowings:

The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings, generally maturing within ninety days, approximate their fair values resulting in a Level 2 classification.

Long-term Debt:

The fair values of the Company’s long-term borrowings are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 2 classification.

The fair values of the Company’s subordinated debentures are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 3 classification.

Accrued Interest Payable:

The carrying amount of accrued interest approximates fair value resulting in a Level 2 or Level 3 classification consistent with the liability they are associated with.