EX-13 11 exh13.txt ANNUAL REPORT EXHIBIT 13 INCORPORATED BY REFERENCE, PAGE 16 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with the audited financial statements and related notes found on pages 29 to 47 as they contain important information helpful in evaluating the Company's operating results and financial condition. (Note: A glossary of certain terms used in this discussion can be found on page 27. Defined terms are italicized the first time they appear in the text.) OVERVIEW Erie Indemnity Company (the Company) is a Pennsylvania business corporation formed in 1925 to be the attorney-in-fact for Erie Insurance Exchange (the Exchange), a Pennsylvania domiciled reciprocal insurance exchange. The Company's principal business activity consists of management of the affairs of the Exchange. Management fees received from the Exchange account for the majority of the Company's consolidated revenues. The Company also is engaged in the property/casualty insurance business through its wholly-owned subsidiaries, Erie Insurance Company, Erie Insurance Property & Casualty Company, and Erie Insurance Company of New York and through its management of Flagship City Insurance Company (Flagship), a subsidiary of the Exchange. The Company also has a 21.63 percent common stock interest in Erie Family Life Insurance Company (EFL), an affiliated life insurance company. Together with the Exchange, the Company and its subsidiaries and affiliates operate collectively under the name Erie Insurance Group. In its role as attorney-in-fact for the Policyholders of the Exchange, the Company may charge a management fee up to 25 percent of the affiliated assumed and direct premiums written by the Exchange. The Company's Board of Directors has the authority to change the management fee at its discretion. The Company's Board of Directors also acts in a fiduciary capacity with respect to the operation of the Exchange. The management fee is compensation for: (a) acting as attorney-in-fact for the Exchange, (b) managing the business and affairs of the Exchange, and (C) paying certain general administrative expenses not part of the settlement of losses or the management of investments. All premiums collected, less the management fee paid to the Company, are retained by the Exchange for the purpose of paying losses, loss adjustment expenses, investment expenses and other miscellaneous expenses including insurance-related taxes, licenses and fees, certain information technology costs covered under a technology cost-sharing agreement, and for other purposes that are to the benefit of the Policyholders. The management fee rate charged the Exchange was 25 percent for each year from 1999 to 2001. In December 2001, the Board voted to maintain the 25 percent management fee rate for all of 2002. Erie Insurance Property & Casualty Company, Flagship, Erie Insurance Company and Erie Insurance Company of New York participate in an intercompany pooling agreement with the Exchange. Under the pooling agreement, all property/casualty insurance business of the Erie Insurance Group is ceded to the Exchange. This pooling agreement provides for Erie Insurance Company and Erie Insurance Company of New York to share proportionately through retrocession in the results of all property/casualty insurance operations of the Exchange and the Company's subsidiaries, except for the provisions of the excess of loss reinsurance agreement discussed below. Erie Insurance Company's and Erie Insurance Company of New York's proportionate share of the reinsurance pool is 5.0 percent and 0.5 percent, respectively. Erie Insurance Company and Erie Insurance Company of New York also have in effect an all-lines aggregate excess of loss reinsurance agreement with the Exchange. This reinsurance treaty is excluded from the intercompany pooling agreement and limits the amount of sustained ultimate net losses in any applicable accident year for the Erie Insurance Company and Erie Insurance Company of New York. The results of the Company's insurance operations are affected by the conditions that affect all property/casualty insurance companies, such as increased competition, catastrophic events, terrorist actions, changes in the regulatory and legislative environments and changes in general economic and investment conditions. 49 INCORPORATED BY REFERENCE, PAGES 16 AND 17 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS RESULTS OF OPERATIONS OVERVIEW Consolidated net income in 2001 was $122,261,396, a decrease of 19.8 percent from the 2000 net income of $152,393,015. Gains made in the Company's management operations, including a 15.1 percent increase in management fee revenue, were outpaced by losses experienced in the Company's insurance underwriting operations and reduced levels of income from investment operations. The 2001 underwriting loss resulted from increased losses in the direct business of the Company's property/casualty subsidiaries, primarily in private passenger and commercial automobile and workers' compensation insurance, as well as assumed reinsurance losses, some of which relate to the September 11th terrorist attacks on the World Trade Center. The Company recognized $31,879,174 in net realized losses from investments in 2001 on the sale of securities and related charges for other-than-temporary impairments of equity securities and limited partnerships. Operating income (net income excluding realized gains/losses and related federal income taxes) increased to $142,982,859 in 2001 from $141,363,933 in 2000. Operating income per share for 2001 was $2.00 per share, an increase of 2.0 percent from $1.96 per share in 2000. Operating income in 2001 reflects a third quarter after-tax charge of $3,795,639, or $.06 per share, from the World Trade Center terrorist attacks and a fourth quarter after-tax charge of $6,933,732, or almost $.10 a share, for severance charges related to the retirement of the Company's chief executive officer. Operating income in 2000 included adverse development on assumed reinsurance losses from the catastrophic storms that devastated Europe in December 1999 contributing $1.4 million, or $.01 per share, after federal income taxes. ANALYSIS OF MANAGEMENT OPERATIONS Net revenue from management operations rose 16.3 percent to $184,567,670 in 2001 from $158,746,324 in 2000 and 6.9 percent in 2000 from $148,517,964 in 1999. Gross margins from management operations were 27.9 percent in 2001 compared to gross margins of 27.6 percent in 2000 and 28.1 percent in 1999. Management fee revenue derived from the direct and affiliated assumed premiums of the Exchange rose $83,319,843, or 15.1 percent, to $634,965,490 in 2001 from $551,645,647 in 2000. (See page 18 "Management Fee Revenue by State and Line of Business.") The direct and affiliated assumed premiums of the Exchange grew 15.1 percent in 2001 to $2,539,861,960 from $2,206,582,573 in 2000. Increases in average premium per policy, improvements in new policy growth and favorable policy retention rates were all contributing factors in the growth. Firming pricing in 2001 for commercial and personal insurance have allowed the Company's property/casualty subsidiaries and affiliates to more adequately price its products while maintaining its competitive advantage in the insurance marketplace. The year-to-year growth rate of direct written premium in the fourth quarter was 18.9 percent, up from 14.8 percent growth in the third quarter, 14.0 percent growth in the second quarter and 12.8 percent growth in the first quarter of 2001. The average premium per policy increased 6.1 percent to $817 in 2001 from $770 in 2000. For personal auto (which accounted for 54.6 percent of the direct written premiums of the Group and over 1.4 million policies in force), the average premium per policy increased 3.1 percent to $967 in 2001 from $938 in 2000. Continued improvement in new policy growth also drove the gains experienced in the Group's direct written premium. Policies in force increased 8.5 percent to 3,109,583 in 2001 from 2,865,553 in 2000 and 6.5 percent in 2000 from 2,689,849 in 1999. Policy retention has remained excellent at 90.9 percent, 91.0 percent and 90.5 percent for the years ended December 31, 2001, 2000 and 1999, respectively, for all lines of business combined. Service agreement revenue for the Company grew 20.2 percent to $27,247,018 in 2001 from $22,662,133 in 2000 and 46.8 percent from $15,440,862 in 1999. Included in service agreement revenue are service charges the Company collects from Policyholders for providing extended payment terms on policies written by the Group. Such service charges amounted to $15,996,469, $12,512,783 and $7,282,621 in 2001, 2000 and 1999, respectively. The 2001 and 2000 growth was positively impacted by service charge increases from $2 to $3 per installment for policies renewing in most states beginning in the second quarter of 2000. Also included in service agreement revenue is service income received from 50 INCORPORATED BY REFERENCE, PAGE 18 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS the Exchange as compensation for the management and administration of voluntary assumed reinsurance from non-affiliated insurers. The Company receives a service fee of 7.0 percent of nonaffiliated assumed reinsurance premiums. These fees totaled $11,250,549, $10,149,350 and $8,158,241 on net voluntary assumed reinsurance premiums of $160,722,122, $144,990,714 and $116,546,295 for 2001, 2000 and 1999, respectively. The cost of management operations rose 14.9 percent to $477,644,838 in 2001 from $415,561,456 in 2000 and 9.3 percent in 2000 from $380,298,179 in 1999. Commissions to independent Agents, which are the largest component of the cost of management operations, include scheduled commissions earned by independent Agents on premiums written, as well as promotional incentives for Agents and Agent contingency awards. Agent contingency awards are based upon a threeyear average of the underwriting profitability of the direct business written and serviced within the Erie Insurance Group by the independent Agent. Commission costs rose 14.3 percent to $323,067,677 in 2001 from $282,746,734 in 2000 and 7.5 percent in 2000 from $263,112,139 in 1999. Commission costs grew at a slower rate relative to the growth in direct premiums written in 2001 as a result of lower accruals for Agent contingency awards compared to 2000. The provision for Agent contingency awards totaled $15,692,870, $18,277,468 and $19,871,036 in 2001, 2000 and 1999, respectively. Commission costs, excluding Agent contingency awards, increased 16.2 percent in 2001, which is in line with the increase in direct written premiums. The cost of management operations, excluding commission costs, increased 16.4 percent in 2001 to $154,577,161 from $132,814,722 in 2000 due primarily to increases in personnel costs. The Company's personnel costs, net of reimbursement from affiliates, totaled $94,361,308, $79,318,446 and $69,484,788 in 2001, 2000 and 1999, respectively. A portion of the increase in personnel costs resulted from recognition of the severance obligation related to the retirement of the Company's president and chief executive officer on January 18, 2002. The Company recorded a severance charge in the fourth quarter 2001 of $10,667,280. Personnel costs, excluding the severance charge, rose 5.5 percent in 2001 due to increases in Employee pay rates and staffing levels. During 2001, the Company and the property/casualty insurance companies of the Erie Insurance Group entered into a cost-sharing agreement for information technology development. This agreement describes how member companies of the Erie Insurance Group will share the costs to be incurred for the development of new Internet-enabled property/casualty policy administration and customer relationship management systems. This agreement provides that the application development costs and the related enabling technology costs, such as technical infrastructure and architectural tools, will be shared among the property/casualty insurance companies in a manner consistent with the sharing of insurance transactions under the existing intercompany pooling agreement. These technology costs are included in the policy acquisition and other underwriting expenses on the Company's Consolidated Statements of Operations. Management fee revenue by state and line of business For the year ended December 31, 2001 (dollars in thousands)
All Other Private Commercial Commercial Workers' Lines of State Passenger Auto Auto Homeowners Multi Peril Compensation Business Total ----------------------------------------------------------------------------------------------------------------------- District of Columbia $ 548 $ 108 $ 247 $ 510 $ 595 $ 117 $ 2,125 Illinois 3,075 645 1,048 1,667 1,010 223 7,668 Indiana 13,309 1,721 5,742 2,846 2,041 845 26,504 Maryland 40,521 6,869 12,689 6,383 6,311 2,671 75,444 New York 10,319 1,887 2,654 3,010 1,645 494 20,009 North Carolina 11,948 4,718 6,171 5,255 3,993 1,384 33,469 Ohio 29,094 4,312 9,619 7,123 0 1,697 51,845 Pennsylvania 193,280 23,004 50,042 27,319 26,801 7,806 328,252 Tennessee 3,712 1,378 1,450 1,830 1,278 386 10,034 Virginia 22,413 5,404 7,695 6,254 6,993 1,958 50,717 West Virginia 18,070 2,644 4,115 2,757 0 838 28,424 Wisconsin 191 52 68 63 78 23 475 ------------------------------------------------------------------------------------------------------------------------ Total $346,480 $ 52,742 $ 101,540 $ 65,017 $ 50,745 $ 18,442 $ 634,966 ========================================================================================================================
51 INCORPORATED BY REFERENCE, PAGE 19 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS Also included as part of this eCommerce program are information technology infrastructure expenditures that are not subject to the cost-sharing agreement for information technology. These eCommerce program costs are included in the cost of management operations in the Company's Consolidated Statements of Operations. These costs totaled $1,588,878 in 2001. (See additional discussion of this program under "Analysis of Insurance Underwriting Operations" and "Factors That May Affect Future Results.") ANALYSIS OF INSURANCE UNDERWRITING OPERATIONS The Company recorded underwriting losses of $20,462,530, $10,402,120 and $3,538,884 in 2001, 2000 and 1999, respectively. The underwriting results in 2001 reflect higher losses experienced in private passenger auto, and commercial automobile and workers' compensation lines of business, as well as losses from assumed reinsurance. Premiums earned increased $13,940,059, or 11.3 percent, to $137,648,253 in 2001 while losses and loss adjustment expenses incurred increased $17,636,989, or 17.7 percent, to $117,201,017 in 2001. The average premium per policy of the Erie Insurance Group was $817, $770 and $763 in 2001, 2000 and 1999, respectively. The Company's property/casualty insurance subsidiaries' share of the Group's direct business generated net underwriting losses of $16,358,294, $6,437,501 and $946,925 in 2001, 2000 and 1999, respectively. In 2001, the Group continued to experience a decrease in loss frequency; however, loss severity continued to rise. The higher loss costs in 2001 also include adverse development of prior accident year losses amounting to $5.9 million, net of reinsurance recoveries. In 1998 and 1999, the Group lowered prices in the private passenger automobile lines of insurance in response to extremely competitive market conditions and improving loss trends in auto insurance. The firming of auto pricing in 2001 by the industry in response to deteriorating loss cost trends have allowed the Group to begin raising auto insurance prices in order to improve underwriting profitability. All policies issued by the Group are for a one-year term. Therefore, the impact of the rate increases will take at least one year before the full impact is recognized in the underwriting results of the Company. Catastrophes are an inherent risk of the property/casualty insurance business and can have a material impact on the Company's insurance underwriting results. In addressing this risk, the Company employs what it believes are reasonable underwriting standards and monitors its exposure by geographic region. Additionally, the Company's property/casualty insurance subsidiaries' excess of loss reinsurance agreement with the Exchange should substantially mitigate the effect of catastrophe losses on the Company's financial position. During 2001, 2000 and 1999, the Company's share of catastrophe losses from direct business amounted to $1.6 million, $2.1 million and $4.4 million, respectively. The Company's property/casualty insurance subsidiaries' unaffiliated voluntary assumed reinsurance business generated net underwriting losses of $4,104,236, $3,964,619 and $2,591,959 in 2001, 2000 and 1999, respectively. Contributing to the 2001 increased loss are the Company's 5.5 percent share of the Erie Insurance Group's estimated incurred reinsurance losses of $150 million from the September 11th terrorist attacks on the World Trade Center. The Company's share of these losses, resulting from its property/casualty insurance subsidiaries' participation in the intercompany pooling agreement with the Exchange, totaled $8,250,000 in 2001, before consideration of recoveries under an excess of loss reinsurance agreement with the Exchange. The agreement reduces the net retention on September 11th losses recorded by the Company to $5,839,445. In late 2001, the Company took measures to improve the underwriting results from its non-affiliated assumed reinsurance book of business. The effects of these measures will be to lower the Company's exposure to loss by excluding terrorism coverage on certain treaties and, at the same time, raising pricing substantially. Pricing in the reinsurance marketplace has firmed considerably since the events of September 11th and the Company is obtaining significant price increases in its 2002 treaty renewals. During 2001, the Company's property/casualty insurance subsidiaries, Erie Insurance Company and Erie Insurance Company of New York, recorded $7,241,235 in reinsurance recoveries under the excess of loss reinsurance agreement with the Exchange. Of the total recoveries in 2001, $6,505,716 relates to accident year 2001 (including the losses related to the World Trade Center), with the balance pertaining to the 1999 accident year. The total recoverable reduces the analysis 52 INCORPORATED BY REFERENCE, PAGES 19 AND 20 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS of Company's loss and loss adjustment expenses in 2001. No cash payments have been made between the companies in 2001 for these recoveries. There were no such recoveries recognized in calendar years 2000 or 1999. Included in the Company's policy acquisition and other underwriting expenses is the property/casualty insurance subsidiaries' share of costs related to the eCommerce initiative totaling $1,314,734 for 2001. The costs stem from the technology cost-sharing agreement described in the analysis of management operations section above, and will continue to increase as the program develops through 2002 and 2003. Also included in underwriting expenses in 2001 is a charge of $1,655,926 for state guaranty fund assessments related to the insolvency of the Reliance Insurance Company. The 2001 combined ratio for the Company's property/casualty insurance operations calculated under Generally Accepted Accounting Principles (GAAP) was 114.9 compared to 108.4 in 2000 and 103.0 in 1999. The GAAP combined ratio for 2001, 2000 and 1999, excluding catastrophe losses on direct business, was 113.7, 106.7 and 99.3, respectively. ANALYSIS OF INVESTMENT OPERATIONS Net revenue from investment operations was $18,770,702 in 2001 compared to $75,593,393 in 2000 and $63,775,746 in 1999. In 2001, the equity markets declined and recovery was further slowed by the September 11th terrorist attacks. As a result, the Company experienced valuation declines in its investment portfolios over the past year. Net realized losses totaled $31,879,174 in 2001 compared to realized gains of $16,967,819 in 2000 and $14,745,334 in 1999. The Company recognized realized losses in 2001 as a result of the sale of securities and charges for other-than-temporary impairments of preferred stock and limited partnerships. The 2001 sales of investments in a loss position was part of a proactive year-end tax selling strategy. Net realized losses from sales of securities totaled $27,291,573, of which $9.6 million is expected to be recovered in federal income taxes paid in 1998, 1999 and 2000. Of this total realized loss, $4.5 million relates to sales of securities of Enron Corporation and its related legal entities. Impairment charges of investments with declines in value considered by management to be other-than-temporary totaled $4,587,601 in 2001. Net investment income rose 3.1 percent to $49,883,896 for the year ended December 31, 2001 and 11.7 percent to $48,400,343 for the year ended December 31, 2000. The growth in investment income for 2001, 2000 and 1999 was affected by cash outflows used by the Company to repurchase its shares which, through December 31, 2001, totaled $93.4 million. Included in net investment income are primarily interest and dividends on the Company's fixed maturity and equity security portfolios. Equity in losses of limited partnerships were $6,731 for the year ended December 31, 2001, compared to earnings of $4,733,285 and $640,925 in 2000 and 1999, respectively. Private equity and fixed income limited partnerships realized losses of $1,430,816 in 2001 compared to earnings of $2,807,632 in 2000. Real estate limited partnerships reflected earnings of $1,424,085 in 2001 compared to earnings of $1,925,653 in 2000. The Company's earnings from its 21.6 percent ownership of Erie Family Life Insurance Company (EFL) totaled $772,711 in 2001, down from $5,491,946 in 2000 and $5,045,131 in 1999. The decrease in level of earnings from the Company's investment in Erie Family Life is related to sales of investments in 2001 resulting in net realized losses on EFL's Statement of Operations. This investment is accounted for under the equity method of accounting. 53 INCORPORATED BY REFERENCE, PAGES 20 AND 21 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS FINANCIAL CONDITION INVESTMENTS The Company's investment strategy takes a long-term perspective emphasizing investment quality, diversification and superior investment returns. Investments are managed on a total return approach that focuses on current income and capital appreciation. The Company's investment strategy also provides for liquidity to meet the short- and long-term commitments of the Company. At December 31, 2001 and 2000, the Company's investment portfolio of investment-grade bonds, common stock, preferred stock and cash and cash equivalents represents 42.6 percent and 46.1 percent, respectively, of total assets. These investments provide the liquidity the Company requires to meet the demands on its funds. Distribution of investments Carrying value at December 31, (dollars in thousands) 2001 % 2000 % ---------------------------------------- Fixed maturities $ 559,873 67 $ 531,546 66 Equity securities: Preferred stock 130,007 15 109,081 13 Common stock 63,791 7 95,365 12 Limited partnerships 81,596 10 68,242 8 Real estate mortgage loans 5,700 1 6,581 1 ---------------------------------------- Total investments $ 840,967 100 % $ 810,815 100 % ======================================== The Company reviews the investment portfolio to evaluate positions that might incur other-than-temporary declines in value. For all investment holdings, general economic conditions and/or conditions specifically affecting the underlying issuer or its industry are considered in evaluating impairment in value. In addition to specific factors, the primary factors considered in the Company's review of investment valuation are the length of time the market value is below cost and the amount the market value is below cost. For common equity securities (including equity limited partnerships) where the decline in market value is more than 20 percent below cost for a period exceeding six months, there is a presumption of impairment. The Company considers market conditions, industry characteristics and the fundamental operating results of the issuer before deciding to sell the investment at a loss or to recognize an impairment charge to operations. For common equity securities that have declined more than 20 percent below cost for a period exceeding twelve months, the position is either sold or recognized as impaired and a charge to operations is recognized as realized losses through the Consolidated Statements of Operations. For fixed maturity investments, the Company individually analyzes all positions whose market value have declined more than 20 percent below cost for a period exceeding six months. The Company considers market conditions, industry characteristics and the fundamental operating results of the issuer to determine if the decline is due to changes in interest rates, changes relating to a decline in credit quality, or other issues affecting the investment. Positions that have incurred market price decline of over 20 percent for a period greater than six months where the creditworthiness of the issuer indicates a decline that is other-than-temporary are either sold or recognized as impaired and reflected as a charge to the Company's operations. If the Company's policy for determining the recognition of impaired positions were different, the Company's Consolidated Statements of Financial Position and results of operations could be significantly impacted. Management believes its investment valuation philosophy and accounting practices result in appropriate and timely measurement of value and recognition of impairment. 54 INCORPORATED BY REFERENCE, PAGES 21 AND 22 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS FIXED MATURITIES. Under its investment strategy, the Company maintains a fixed maturities portfolio that is of very high quality and well diversified within each market sector. The fixed maturities portfolio is managed with the goal of achieving reasonable returns while limiting exposure to risk. At December 31, 2001, the carrying value of fixed maturity investments represented 66.6 percent of total invested assets. The Company's fixed maturity investments consist 96.9 percent of high-quality, marketable bonds and redeemable preferred stock, all of which were rated at investment-grade levels (above Ba/BB) at December 31, 2001. Included in this investment-grade category are $230.2 million, or 41.1 percent, of the highest quality bonds and redeemable preferred stock rated Aaa/AAA or Aa/AA or bonds issued by the United States government. Generally, the fixed maturities in the Company's portfolio are rated by external rating agencies. If not externally rated, they are rated by the Company on a basis consistent with that used by the rating agencies. Management classifies all fixed maturities as available-for-sale securities, allowing the Company to meet its liquidity needs and provide greater flexibility for its investment managers to appropriately respond to changes in market conditions or strategic direction. Securities classified as available-for-sale are carried at market value with unrealized gains and losses included in shareholders' equity. At December 31, 2001, the net unrealized gain on fixed maturities, net of deferred taxes, amounted to $10,693,076 compared to $4,793,120 at December 31, 2000. The Company's investment strategy achieves a balanced maturity schedule in order to moderate investment income in the event of interest rate declines in a year in which a large amount of securities could be redeemed or mature. EQUITY SECURITIES. Equity securities (common stock and non-redeemable preferred stock) are carried on the Consolidated Statements of Financial Position at market value. At December 31, 2001 and 2000, equity securities held by the Company include net unrealized gains of $22,146,017 and $12,660,439, respectively, net of deferred taxes. Investment characteristics of common and preferred stocks differ substantially from one another. The Company's non-redeemable preferred stock portfolio provides a source of highly predictable current income that is competitive with investment-grade bonds. Non-redeemable preferred stocks generally provide for fixed rates of return that, while not guaranteed, resemble fixed income securities and are paid before common stock dividends. Common stock provides capital appreciation potential within the portfolio. Common stock investments inherently provide no assurance of producing income because dividends are not guaranteed. LIMITED PARTNERSHIP INVESTMENTS. The Company's limited partnership investments include U.S. and foreign private equity, real estate and fixed income investments. During 2001, limited partnership investments increased $13,354,660 to $81,596,108. Fixed income and real estate limited partnerships, which comprise 34.5 percent of the total limited partnerships, produce a predictable earnings stream while private equity limited partnerships, which comprise 65.5 percent of the total limited partnerships, tend to provide a less predictable earnings stream but the potential for greater long-term returns. The Company has outstanding commitments to invest up to $124 million related to these limited partnership investments at December 31, 2001. These commitments will be funded as required through the end of the respective investment periods, which typically span three to five years and principally expire in 2005. At December 31, 2001, the total commitment to fund limited partnerships that invest in private equity securities is $87 million, real estate activities $22 million and fixed income securities $15 million. At December 31, 2001, no one commitment exceeded $7.5 million, or 6 percent, of the outstanding commitment amount. The Company has sufficient cash flows from operations to meet these partnership commitments. INVESTMENT IN EFL. EFL markets various life insurance products, principally non-participating individual and group life policies, including universal life and individual and group annuity products, in eleven jurisdictions. The Company's carrying value of $44,683,170 represents 21.63 percent of the shareholders' equity of EFL at December 31, 2001. LIABILITIES PROPERTY/CASUALTY LOSS RESERVES. Loss reserves are established to account for the estimated ultimate costs of loss and loss adjustment expenses for claims 55 INCORPORATED BY REFERENCE, PAGE 22 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS that have been reported but not yet settled and claims that have been incurred but not reported. The estimated loss reserve for reported claims is based primarily upon a case-by-case evaluation of the type of risk involved and knowledge of the circumstances surrounding each claim and the insurance policy provisions relating to the type of loss. Estimates of reserves for unreported claims and loss settlement expenses are determined on the basis of historical information by line of insurance as adjusted to current conditions. Loss reserves are set at full expected cost, except for loss reserves for workers' compensation which have been discounted at 2.5 percent in 2001 and 2000. Inflation is implicitly provided for in the reserving function through analysis of costs, trends and reviews of historical reserving results. The process of estimating the liability for unpaid losses and loss expenses is inherently judgmental and can be influenced by factors subject to variation. Possible sources of variation include claim frequency and severity, changing rates of inflation as well as changes in other economic conditions, judicial trends and legislative changes. It is unlikely that future losses and loss adjustment expenses will develop exactly as projected. The Company continually refines reserves as experience develops and new information becomes known. The Company reflects adjustments to reserves in the results of operations in the periods in which the estimates are changed. At December 31, 2001, the property/casualty insurance companies managed by the Company had estimated total loss exposure related to the events of September 11th of $150 million. Only a nominal amount to date has been paid on losses related to September 11th, which adds greater uncertainty to the loss estimates. Additionally, disputes concerning whether the September 11th attack on the World Trade Center should be considered one or two insurable events are currently being litigated. The Company's $150 million loss estimate anticipates that the events of September 11th is considered one event. If the attack comes to be considered as two events, the total potential exposure for the Erie Insurance Group would increase between $50 million and $75 million. The effect on the Company, as a result, would be additional losses between $2.7 million and $4.1 million. Taking into consideration the excess of loss reinsurance agreement, the net impact of such potential additional losses would be minimal to the Company. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK INTEREST RATE RISK The Company's exposure to market risk for a change in interest rates is concentrated in the investment portfolio. The Company monitors this exposure through periodic reviews of asset and liability positions. Estimates of cash flows and the impact of interest rate fluctuations relating to the investment portfolio are monitored regularly. Generally, the Company does not hedge its exposure to interest rate risk, as it holds fixed maturity investments to maturity. Principal cash flows and related weighted-average interest rates by expected maturity dates for financial instruments sensitive to interest rates are as follows: Weighted- December 31,2001 Principal average (dollars in thousands) cash flows interest rate ----------------------------------------------------------------------- Fixed maturities and short-term bonds: 2002 $ 37,245 6.5% 2003 35,245 6.5% 2004 37,978 7.0% 2005 49,515 6.3% 2006 55,340 6.5% Thereafter 330,872 7.5% ----------------------------------------------------------------------- Total $ 546,195 ----------------------------------------------------------------------- Market Value $ 574,874 ======================================================================= 56 INCORPORATED BY REFERENCE, PAGE 23 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS Weighted- December 31,2000 Principal average (dollars in thousands) cash flows interest rate ----------------------------------------------------------------------- Fixed maturities and short term bonds: 2001 $ 54,677 6.5% 2002 55,203 6.6% 2003 49,720 6.7% 2004 47,852 7.0% 2005 59,775 6.5% Thereafter 289,077 7.2% ----------------------------------------------------------------------- Total $ 556,304 ----------------------------------------------------------------------- Market Value $ 561,502 ======================================================================= Actual cash flows may differ from those stated as a result of calls and prepayments EQUITY PRICE RISK The Company's portfolio of marketable equity securities, which is carried on the Consolidated Statements of Financial Position at estimated fair value, has exposure to price risk, the risk of potential loss in estimated fair value resulting from an adverse change in prices. The Company's objective is to earn competitive relative returns by investing in a diverse portfolio of high-quality, liquid securities. Portfolio characteristics are analyzed regularly and market risk is actively managed through a variety of techniques. Portfolio holdings are diversified across industries; concentrations in any one company or industry are limited by parameters established by management and the Company's Board of Directors. LIQUIDITY AND CAPITAL RESOURCES Liquidity is a measure of an entity's ability to secure enough cash to meet its contractual obligations and operating needs. The Company's major sources of funds from operations are the net cash flow generated from management operations, the net cash flow from Erie Insurance Company's and Erie Insurance Company of New York's 5.5 percent participation in the underwriting results of the reinsurance pool with the Exchange, and investment income from affiliated and nonaffiliated investments. With respect to the management fee, funds are generally received from the Exchange on a premiums collected basis. The other receivable from Erie Insurance Exchange and affiliates represents the management fee receivable from premiums written but not yet collected as well as the management fee receivable on premiums collected in the current month, net of operating expenses paid by the Exchange. The Company pays commissions on premiums collected rather than premiums written. Cash outflows are variable because of the fluctuations in settlement dates for liabilities for unpaid losses and because of the potential for large losses, either individually or in aggregate. The Company generates sufficient net positive cash flow from its operations to fund its commitments and build its investment portfolio, thereby increasing future investment returns. The Company maintains a high degree of liquidity in its investment portfolio in the form of readily marketable fixed maturities, equity securities and short-term investments. Net cash flows provided by operating activities for the years ended December 31, 2001, 2000 and 1999, were $148,607,987, $130,614,256 and $136,967,568, respectively. The Company pays nearly all general and administrative expenses on behalf of the Exchange and other affiliated companies. The Exchange generally reimburses the Company for these expenses on a paid basis each month. Management fee and expense reimbursements due at December 31 from the Exchange were $147,344,684 and $117,961,638 in 2001 and 2000, respectively. A receivable from EFL for expense reimbursements totaled $2,255,597 at December 31, 2001, compared to $1,997,012 at December 31, 2000. The Company also has a receivable due from the Exchange for reinsurance recoverable from losses and unearned premium balances ceded to the intercompany reinsurance pool. Such amounts totaled $491,055,048 and $412,049,637 at December 31, 2001 and 2000, respectively. Beginning in 1999, the Company established a stock repurchase program. The Company may repurchase as much as $120 million of its outstanding Class A common stock through December 31, 2002. In 2001, there were 220,000 shares repurchased at a total cost of $7,653,916. Since its inception, 3,195,677 shares have been repurchased at a total cost of $93,373,265. The Company may purchase the shares from time to time in the open market or by privately negotiated transactions, depending on prevailing market conditions and alternative uses of the Company's capital. 57 INCORPORATED BY REFERENCE, PAGES 23 AND 24 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS Dividends declared to shareholders totaled $40,407,734, $36,188,667 and $32,802,428 in 2001, 2000 and 1999, respectively. There are no regulatory restrictions on the payment of dividends to the Company's shareholders, although there are state law restrictions on the payment of dividends from the Company's subsidiaries to the Company. Dividends from subsidiaries are not material to the Company's cash flows. Temporary differences between the financial statement carrying amounts and tax bases of assets and liabilities that give rise to deferred tax assets and liabilities resulted in net deferred tax liabilities at December 31, 2001 and 2000 of $12,944,678 and $7,161,544, respectively. The primary reason for the increase in the deferred tax liability is an increase in unrealized gains from available-for-sale securities and limited partnerships in 2001 of $18,013,789 resulting in an increase in deferred tax liability of $6,304,826. Management believes it is likely that the Company will have sufficient taxable income in future years to realize the benefits of the gross deferred tax assets. FINANCIAL RATINGS The following table summarizes the current A.M. Best Company ratings for the insurers managed by the Company: Erie Insurance Exchange A++ Erie Insurance Company A++ Erie Insurance Property & Casualty Company A++ Erie Insurance Company of New York A++ Flagship City Insurance Company A++ Erie Family Life Insurance Company A+ According to A.M. Best, a superior rating (A++ or A+) is assigned to those companies that, in A.M. Best's opinion, have achieved superior overall performance when compared to the standards established by A.M. Best and have a very strong ability to meet their obligations to policyholders over the long term. Financial strength ratings have become increasingly important to the insurers managed by the Company and to the industry in marketing insurance products. REGULATORY RISK-BASED CAPITAL The NAIC standard 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, 2001, the Company's property/casualty insurance subsidiaries' RBC levels are all substantially in excess of levels that would require regulatory action. REINSURANCE RISK The property/casualty insurers managed by the Company do not maintain any ceded reinsurance treaties with unaffiliated insurers due to their strong surplus position, the cost of reinsurance and low ratio of the premium writings to surplus. The Company does not believe the absence of ceded reinsurance treaties will have a material adverse effect, over the long term, on the results of operations of the insurance companies managed by the Company. However, the absence of such treaties could have an adverse effect on the results of operations of the insurance companies managed by the Company in a given year if the frequency or severity of claims were substantially higher than historical averages because of an unusual event or series of events. The Company's reinsurance agreement in effect with the Exchange mitigates catastrophe loss exposure risk to the Company's property/casualty insurance subsidiaries, but does not mitigate the exposure of the Exchange. 58 INCORPORATED BY REFERENCE, PAGES 24 AND 25 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS FACTORS THAT MAY AFFECT FUTURE RESULTS MANAGEMENT OPERATIONS MANAGEMENT FEE RATE. The management fee paid to the Company as attorney-in-fact for the Exchange is subject to approval by the Company's Board of Directors. The rate may be changed periodically by the Board at its discretion but may not exceed 25 percent. The Board considers several factors in determining the management fee rate, including the relative financial position of the Exchange and the Company and the long-term capital needs of the Exchange, in order to foster growth and competitiveness as well as maintain its superior financial strength, which ultimately benefits the entire Erie Insurance Group. Because the management fee revenue from the Exchange provides the majority of the Company's revenue, the income of the Company is dependent upon the ability of the Exchange to maintain its financial condition and its ability to continue to offer competitive insurance products in the marketplace. INSURANCE PRICING CONDITIONS. Given the direct correlation of direct premium written to the management fee revenue of the Company, the premium growth and financial viability of the property/casualty insurers managed by the Company bear directly on the ongoing profitability of the Company. Competitive conditions have exerted downward pressure on property/casualty insurance pricing and characteristically soft market conditions (favoring buyers of insurance) have prevailed for some time in both commercial and personal lines of insurance. During 2001, prices for commercial insurance have firmed considerably and personal lines prices have stabilized and started to trend higher. These trends accelerated after the events of September 11th. The Company continually evaluates pricing levels balancing competitive conditions and the need to maintain the solid financial condition of the insurers it manages. Pricing actions contemplated or taken by the insurers of the Erie Insurance Group are subject to various regulatory requirements of the states in which these insurers operate. Premium increases anticipated in 2002, due to pricing actions contemplated, filed and awaiting approval, or approved through December 31, 2001, could amount to approximately $107 million in premium for the Erie Insurance Group in 2002. The majority of the anticipated increase stems from the private passenger and commercial auto lines of business as well as the homeowner line of business. Further rate actions will be contemplated during 2002 and future years affecting the overall competitiveness and profitability of the Erie Insurance Group and the management fee levels of the Company. The Company also receives service agreement revenue from the Exchange as compensation for management of its voluntary assumed non-affiliated reinsurance business. The Company's service fee is 7 percent of the non-affiliated assumed voluntary reinsurance premiums. During the 2002 reinsurance renewal season, the Exchange has been obtaining significant price increases on treaties it is renewing. On average, renewal rates online are 40 to 50 percent above 2001 rates. However, the Exchange is reducing its aggregate exposure in non-affiliated assumed voluntary reinsurance by non-renewing unprofitable business, excluding terrorism coverage, and restricting exposure on certain types of risks. As a result of raising prices and lowering aggregate exposure in non-affiliated assumed voluntary reinsurance, the Company anticipates reinsurance premium volume will be at or slightly below the 2001 premium level. INSURANCE OPERATIONS GEOGRAPHIC EXPANSION. On December 6, 2001, the Company announced the Erie Insurance Group's intention to expand its operations into Minnesota. Minnesota will be the 12th state served by the Group, in addition to the District of Columbia. Beginning in the third quarter of 2004, the Group intends to write all lines of insurance it currently offers, including auto, home, business, life and annuities in Minnesota. INCURRED BUT NOT REPORTED (IBNR) LOSSES. The insurance companies owned and managed by the Company are exposed to new claims on previously closed files and to larger than historical settlements on pending and unreported claims. The Company is exposed to increased losses by virtue of its 5.5 percent participation in the intercompany reinsurance pooling agreement with the Exchange. 59 INCORPORATED BY REFERENCE, PAGE 25 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS INSURANCE PREMIUM RATE INCREASES. Premium rate filings impact the Company's property/casualty insurance subsidiaries. Rate increases filed in 2001 for the private passenger auto, commercial auto, workers' compensation and homeowners lines of business in various states were sought to offset growing loss costs in these particular lines. See additional discussion of premium levels and pricing in the insurance pricing conditions section above. INSURANCE COMPANY INSOLVENCIES. The insurance companies owned and managed by the Company pay assessments under the solvency or guaranty laws of the various states in which they are licensed. During 2001, the Company received notification of the insolvency of the Reliance Insurance Group. As a result, the Erie Insurance Group property/casualty insurance companies recorded an estimated assessment of $36.8 million, before consideration of potential premium tax recoveries of $5.9 million. The Company's share of this assessment was $1.7 million and was recorded in the policy acquisition and other underwriting expenses during the fourth quarter of 2001. This estimate was based upon preliminary data relating to this insolvency and is subject to change as more information becomes available. There are other insurance company insolvencies that could impact future underwriting results of the Company, one of which is Pennsylvania-based PHICO Insurance Company, which became insolvent in late 2001. The impact of this insolvency on the Company's financial results cannot be reasonably estimated at this time. INFORMATION TECHNOLOGY COSTS. In 2001, the Company began a comprehensive program of eCommerce initiatives in support of the Erie Insurance Group's business model of distributing insurance products exclusively through independent Agents. The eCommerce program includes initiatives to replace property/casualty policy administration systems as well as Agent and customer interaction systems. The program also includes significant information technology infrastructure expenditures. It is intended to improve service and efficiency, as well as result in increased sales. Total threeyear expenditures for the program are estimated at $175 million. The cost of these initiatives will be shared among several companies of the Erie Insurance Group, including the Company. The costs of the eCommerce program reduced aftertax net income of the Company by $0.03 per share for 2001. Current cost estimates indicate an additional reduction in the Company's after-tax earnings per share of between $0.15 and $0.17 per share in 2002 and between $0.04 and $0.06 per share in 2003. REGULATORY FEDERAL CHARTERING. Congress is considering legislation that would create an optional federal charter for insurers. The "Insurance Industry Modernization Act" would establish an Office of National Insurers within the Treasury Department. The office would have the power to charter, license and regulate "national insurers" and its director would be required to establish a Division of Consumer Affairs within the office. The proposed legislation would repeal the McCarran-Ferguson Act, except for the sharing of historical loss data and activities associated with participation in mandatory residual market and workers' compensation mechanisms. Federal chartering has the potential to create an uneven playing field for insurers. Federally chartered companies could be subject to different regulatory requirements than state chartered insurers in the areas of market conduct oversight, solvency regulation, guaranty fund participation and premium tax burdens. If this occurs, federally chartered insurers may obtain a competitive advantage over state licensed carriers. The federal proposal also raises the specter of a matrix of regulation and costly duplicative, or conflicting, federal and state requirements. Finally, the partial repeal of McCarran-Ferguson poses a threat to industry practices, which are currently exempt from antitrust scrutiny. TERRORISM. The tragic September 11th attacks resulted in staggering losses for the insurance industry and have caused uncertainty in the insurance and reinsurance market. The industry has been compelled to re-examine policy language and to address the potential for future threats of terrorist events and losses. ERIE's personal and commercial property and casualty insurance policies were not intended to cover the risk of terrorist events and losses such as those suffered in the September 11th attacks. It is difficult to predict and measure the risks associated with possible future terrorist attacks. 60 INCORPORATED BY REFERENCE, PAGE 26 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS To address the industry's terrorism exposure, insurers have been working with Congress, the White House and other interested parties to enact legislation that would help spread the risk of future terrorist losses. However, no federal backstop legislation has been passed and future legislation is uncertain. Regulators in states in which ERIE does business, with the exception of New York, have approved limited optional terrorism exclusion endorsements for use only on commercial property and liability lines within the framework developed by ISO (Insurance Services Office, Inc.). These endorsements exclude claims for terrorist acts involving the release of biological, chemical, nuclear or radioactive materials. In other incidents of terrorism, thresholds must be met before the exclusion will apply. For both property and liability coverage, insured property damage must exceed $25 million. For liability coverage, the exclusion will also apply if more than 50 people sustain serious physical injury. When the threshold is met, there is no coverage. ERIE has made the necessary filings to obtain approval for use of these optional exclusions where deemed necessary. The National Association of Insurance Commissioners (NAIC) has recently announced a resolution to deny terrorism exclusions on personal lines policies. NAIC action is advisory and states have approval authority; however, it is likely that many states will follow the NAIC resolution. Through its trade organizations and grassroots efforts, ERIE continues to work toward a federal solution. The Company's substantial portfolio of equity and fixed income investments could also be affected by potential future terrorist actions, which may affect the level of economic activity as well as investor confidence in the U.S. capital markets. MOLD. Over the course of the last several years, the industry has experienced several significant jury verdicts handed down in cases involving property damage and personal injuries, arguably related to mold. Potentially, The ERIE could see an increase in the number of claims from both a first party and a third party coverage context. The Company has created a mold task force committee which is in the process of reviewing all of The ERIE's personal and commercial policies in order to determine the feasibility of limiting claims. Presently, the committee is studying various options ranging from an outright exclusion of mold coverage to an exclusion with a buy-back endorsement for coverage. PRIVACY. The insurance industry continues to address compliance issues required by the Gramm Leach Bliley Financial Services Modernization Act (GLBA) and the Health Insurance Portability and Accountability Act (HIPAA). The GLBA places limits on how insurers may use and disclose consumer information. It also requires all financial institutions to adopt internal policies and procedures to protect the privacy and security of consumer information and to deliver an annual privacy notice to all customers. Following delivery of these notices in July 2001, consumer groups complained that the notices were legalistic, complex and generally not "consumer friendly." In response, the NAIC organized a task force to study the adoption of simplified model language for insurer privacy notices. The NAIC has also proposed model regulations that address the security of consumer information and provide standards for insurance departments to measure compliance with privacy laws. In February 2001, the Department of Health and Human Services (HHS) issued regulations under HIPAA requiring health plans, health care providers and health care clearinghouses ("covered entities") to adopt privacy policies for the protection of health information. Regulations have also been adopted to set standards for the electronic transfer of health information. Although the Company's insurance operations are not directly subject to the regulations, the Company will be required to comply if it elects to engage in the electronic transfer of information to and from covered entities. The Company's health plan for Employees, which is a covered entity under the regulations, will be required to reach compliance by April 2003. "Safe Harbor" Statement under the Private Securities Litigation Reform Act of 1995: Certain forward-looking statements contained herein involve risks and uncertainties. Many factors could cause future results to differ materially from those discussed. Examples of such factors include variations in catastrophe losses due to changes in weather patterns, other natural causes or terrorist actions; changes in insurance regulations or legislation that disadvantage the members of the Group in the marketplace and recession; economic conditions or stock market changes affecting pricing or demand for insurance products or ability to generate investment income and returns. Growth and profitability have been and will be potentially materially affected by these and other factors. 61 INCORPORATED BY REFERENCE, PAGE 27 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS Glossary of selected insurance terms Assume: To receive from an insurer or a reinsurer all or part of the insurance or reinsurance written by an insurance or reinsurance entity. Attorney-in-fact: Legal entity (Erie Indemnity Company, a corporate attorney-in-fact) that is legally appointed by another (subscribers of the Exchange) to transact business on its behalf. Cede: To transfer to an insurer or a reinsurer all or part of the insurance or reinsurance written by an insurance or reinsurance entity. Direct premiums written: Premiums on policies written by an insurer with the Policyholder. GAAP combined ratio: Ratio of acquisition and underwriting expenses, losses and loss adjustment expenses incurred to premiums earned, computed under Generally Accepted Accounting Principles. Gross margins from management operations: Net revenues from management operations divided by total revenues from management operations. Incurred but not reported: Estimated liabilities established by an insurer to reflect the losses estimated to have occurred but that are not yet known by the insurer. Losses: An occurrence that is the basis for submission of a claim. Losses may be covered, limited or excluded from coverage, depending on the terms of the policy. "Loss" also refers to the amount of the insurer's liability arising out of the occurrence. Loss adjustment expenses (LAE): The expenses of settling claims, including legal and other fees and expenses, and the portion of general expenses allocated to claim settlement costs. Loss reserves: Estimated liabilities established by an insurer to reflect the estimated cost of claims payments and the related expenses that ultimately will be incurred in respect of insurance it has written. NAIC: The National Association of Insurance Commissioners, an association of the top regulatory officials of all 50 states and the District of Columbia organized to promote consistency of regulatory practices and statutory accounting practices throughout the United States. Policy retention: The percentage of existing Policyholders who renew their policies. Property/casualty insurance: Casualty insurance indemnifies an insured against legal liability imposed for losses caused by injuries to third persons (i.e., not the policyholder). It includes, but is not limited to, employers' liability, workers' compensation, public liability, automobile liability and personal liability. Property insurance indemnifies a person with an insurable interest in tangible property for his property loss, damage or loss of use. Reciprocal insurance exchange: An unincorporated group of persons known as subscribers who, under a common name, exchange insurance contracts with each other for the purpose of providing indemnity among themselves from losses through a common attorney-in-fact. Each subscriber gives a power of attorney under which the attorney-in-fact represents each subscriber in exchanging insurance contracts with the other subscribers. Reinsurance: An instrument through which an insurer cedes to another insurer all or a portion of the risk insured and conveys/pays to that other insurer a portion of the premium received from the insured. Reinsurance makes the assuming reinsurer liable to the extent of the coverage ceded. However, in the event the reinsurer is unable to pay the assumed portion of the loss, the ceding insurer would be responsible for the entire loss. 62 INCORPORATED BY REFERENCE, PAGE 28 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS Selected Segment Information The direct written premiums of the Erie Insurance Group have a direct impact on the Company's management fee revenue and, consequently, the Company's management operations. The Company's insurance underwriting operations are impacted by the mix of the group's direct written premium. Below is a summary of direct written premiums of the Erie Insurance Group by state and line of business.
Years Ended December 31 2001 2000 1999 ------------------------------------------------------------------------------------------------------- Premiums written as a percent of total by state: District of Columbia 0.3 % 0.3 % 0.2 % Illinois 1.2 0.6 0.2 Indiana 4.2 4.0 3.9 Maryland 11.9 11.9 11.9 New York 3.1 2.7 2.2 North Carolina 5.3 4.6 4.1 Ohio 8.2 8.0 7.9 Pennsylvania 51.7 53.9 55.6 Tennessee 1.6 1.4 1.3 Virginia 8.0 8.0 8.1 West Virginia 4.4 4.6 4.6 Wisconsin 0.1 0.0 0.0 ------------------------------------------------------------------------------------------------------ Total direct premiums written 100.00 % 100.00 % 100.00 % Premiums written by line of business: Personal: Automobile 54.6 % 56.9 % 59.5 % Homeowners 16.0 16.1 15.7 Other 1.2 1.3 0.9 ------------------------------------------------------------------------------------------------------ Total personal 71.8 % 74.3 % 76.1 % Commercial: Automobile 8.3 % 7.8 % 7.3 % Workers' compensation 8.0 7.2 6.5 Commercial multi-peril 10.2 9.1 8.3 Other 1.7 1.6 1.8 ------------------------------------------------------------------------------------------------------ Total commercial 28.2 % 25.7 % 23.9 % ------------------------------------------------------------------------------------------------------
The growth rate of policies in force and policy retention trends can impact the Company's management and property/casualty operating segments. Below is a summary of each by line of business for the Erie Insurance Group's property/casualty business.
Years Ended December 31 (amounts in thousands) 2001 2000 1999 --------------------------------------------------------------------------------------------------- Policies in force: Personal lines 2,724 2,517 2,368 Commercial lines 386 349 322 --------------------------------------------------------------------------------------------------- Total policies in force 3,110 2,866 2,690 --------------------------------------------------------------------------------------------------- Policy retention percentages: Personal policy retention percentages 91.3% 91.5% 91.0% Commercial policy retention percentages 87.7% 85.9% 84.1% Total policy retention percentages 90.9% 91.0% 90.5% ---------------------------------------------------------------------------------------------------
63 Index to Graphs included in the Management's Discussion and Analysis GRAPH NUMBER AMOUNTS TO GRAPH Graph # 1 ========= NET REVENUE FROM MANAGEMENT OPERATIONS AND GROSS MARGINS (In millions of dollars, except ratios) 1999 2000 2001 ----------------------- Net Revenue from Management Operations $148.5 $158.7 $184.6 Gross Margin from Management Operations 28.1% 27.6% 27.9% Pie Chart # 1 ============= Diversification of fixed maturities at December 31, 2001 U.S. Industrial & Miscellaneous 57% Special Revenue 20% States & Political Subdivisions 8% Foreign 5% Public Utilities 5% Redeemable preferred stock 3% Other 2% Pie Chart # 2 ============= Quality* of fixed maturities Carrying Value at December 31, 2001 Baa/BBB 32% Aaa/AAA 27% A 24% Aa/AA 14% Ba/BB or lower 3% * As rated by Standard & Poor's or Moody's Investor's Service, Inc. Pie Chart # 3 ============= Diversification of equity securities at December 31, 2001 - Carrying Value (1) U.S. Industrial & Miscellaneous 31% (1) U.S. Banks, Trusts & Insurance Co's 2% (2) U.S. Industrial & Miscellaneous 47% (2) Foreign 11% (2) U.S. Banks, Trusts & Insurance Co's 8% (2) Public Utilities 1% (1) Common Stock (2) Nonredeemable Preferred Stock 64 INCORPORATED BY REFERENCE, PAGE 29 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS REPORT OF MANAGEMENT The management of Erie Indemnity Company is responsible for the preparation of information included in the financial statements in this annual report to shareholders. The financial statements have been prepared in conformity with Generally Accepted Accounting Principles. The balances in the financial statements are developed from the financial records of the Company and reflect estimates using judgment where amounts cannot be measured precisely or for transactions not yet complete. The Company's system of internal control is designed to safeguard Company assets from unauthorized use or disposition and to provide for proper authorization, execution and recording of Company transactions. Company personnel design, maintain and monitor internal control on an ongoing basis. In addition, the Company's internal auditors review and report on the functioning of various aspects of internal control. The Audit Committee of the Board of Directors, composed of outside directors, meets periodically with the Company's management, internal auditors and independent auditors to review the work of each and to inquire as to their assessment of the performance of Company financial personnel. The independent auditors and internal auditors have full and free access to the Audit Committee, without the presence of management, to discuss results of work performed and communicate other appropriate matters. /s/ Jan R. Van Gorder Jan R. Van Gorder Acting President and Chief Executive Officer February 7, 2002 /s/ Philip A. Garcia Philip A. Garcia Executive Vice President and Chief Financial Officer February 7, 2002 /s/ Timothy G. NeCastro Timothy G. NeCastro Senior Vice President and Controller February 7, 2002 INDEPENDENT AUDITORS' REPORT ON THE CONSOLIDATED FINANCIAL STATEMENTS To the Board of Directors and Shareholders Erie Indemnity Company Erie, Pennsylvania We have audited the accompanying Consolidated Statements of Financial Position of Erie Indemnity Company and subsidiaries as of December 31, 2001 and 2000, and the related Consolidated Statements of Operations, Shareholders' Equity, and Cash Flows for each of the three years in the period ended December 31, 2001. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Erie Indemnity Company and subsidiaries as of December 31, 2001 and 2000, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2001 in conformity with accounting principles generally accepted in the United States of America. /s/ Malin, Bergquist & Company, LLP Malin, Bergquist & Company, LLP Erie, Pennsylvania February 7, 2002 65 INCORPORATED BY REFERENCE, PAGE 31 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS
ERIE INDEMNITY COMPANY CONSOLIDATED STATEMENTS OF FINANCIAL POSITION As of December 31, 2001 and 2000 (Dollars in thousands) ASSETS 2001 2000 ----------- ----------- Investments: Fixed maturities at fair value (amortized cost of $543,423 and $524,172, respectively) $ 559,873 $ 531,546 Equity securities at fair value (cost of $159,727 and $184,968, respectively) 193,798 204,446 Limited partnerships (cost of $79,668 and $60,661, respectively) 81,596 68,242 Real estate mortgage loans 5,700 6,581 ---------- ---------- Total investments $ 840,967 $ 810,815 Cash and cash equivalents 88,213 38,778 Accrued investment income 9,138 9,087 Premiums receivable from Policyholders 186,175 156,269 Prepaid federal income taxes 14,056 3,604 Reinsurance recoverable from Erie Insurance Exchange 491,055 412,050 Note receivable from Erie Family Life Insurance Company 15,000 15,000 Other receivables from Erie Insurance Exchange and affiliates 149,600 119,959 Reinsurance recoverable from non-affiliates 372 712 Deferred policy acquisition costs 17,018 13,202 Property and equipment 14,635 13,856 Equity in Erie Family Life Insurance Company 44,683 42,331 Other assets 64,654 44,936 ---------- ---------- Total assets $1,935,566 $1,680,599 ========== ========== See accompanying notes to consolidated financial statements
66 INCORPORATED BY REFERENCE, PAGE 31 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS
ERIE INDEMNITY COMPANY CONSOLIDATED STATEMENTS OF FINANCIAL POSITION (CONTINUED) As of December 31, 2001 and 2000 (Dollars in thousands) LIABILITIES AND SHAREHOLDERS' EQUITY 2001 2000 ---------- ---------- LIABILITIES Unpaid losses and loss adjustment expenses $ 557,278 $ 477,879 Unearned premiums 311,969 263,855 Commissions payable and accrued 110,121 96,823 Accounts payable and accrued expenses 46,164 30,476 Deferred income taxes 12,945 7,161 Dividends payable 10,930 9,839 Employee benefit obligations 20,904 15,551 ---------- ---------- Total liabilities $1,070,311 $ 901,584 ---------- ---------- SHAREHOLDERS' EQUITY Capital stock Class A common, stated value $.0292 per share; authorized 74,996,930 shares; 67,032,000 shares issued; 63,836,323 and 64,056,323 shares outstanding in 2001 and 2000, respectively $ 1,955 $ 1,955 Class B common, stated value $70 per share; authorized 3,070 shares; 3,070 shares issued and outstanding 215 215 Additional paid-in capital 7,830 7,830 Accumulated other comprehensive income 35,222 23,182 Retained earnings 913,406 831,552 ---------- ---------- Total contributed capital and retained earnings $ 958,628 $ 864,734 Treasury stock, at cost, 3,195,677 shares in 2001 and 2,975,677 in 2000 ( 93,373) ( 85,719) ---------- ---------- Total shareholders' equity $ 865,255 $ 779,015 ---------- ---------- Total liabilities and shareholders' equity $1,935,566 $1,680,599 ========== ========== See accompanying notes to consolidated financial statements
67 INCORPORATED BY REFERENCE, PAGE 30 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS
ERIE INDEMNITY COMPANY CONSOLIDATED STATEMENTS OF OPERATIONS Years Ended December 31, 2001, 2000 and 1999 (Amounts in thousands, except per share data) 2001 2000 1999 ------------------------------------------ MANAGEMENT OPERATIONS: Management fee revenue $ 634,966 $ 551,646 $ 513,375 Service agreement revenue 27,247 22,662 15,441 --------- --------- --------- Total revenue from management operations 662,213 574,308 528,816 Cost of management operations 477,645 415,562 380,298 --------- --------- --------- Net revenue from management operations $ 184,568 $ 158,746 $ 148,518 --------- --------- --------- INSURANCE UNDERWRITING OPERATIONS: Premiums earned $ 137,648 $ 123,708 $ 117,224 --------- --------- --------- Losses and loss adjustment expenses incurred 117,201 99,564 87,719 Policy acquisition and other underwriting expenses 40,910 34,546 33,044 --------- --------- --------- Total losses and expenses $ 158,111 $ 134,110 $ 120,763 --------- --------- --------- Underwriting loss ($ 20,463) ($ 10,402) ($ 3,539) --------- --------- --------- INVESTMENT OPERATIONS: Net investment income $ 49,884 $ 48,401 $ 43,344 Net realized (losses) gains on investments ( 31,879) 16,968 14,746 Equity in earnings of Erie Family Life Insurance Company 773 5,492 5,045 Equity in (losses) earnings of limited partnerships ( 7) 4,733 641 --------- --------- --------- Net revenue from investment operations $ 18,771 $ 75,594 $ 63,776 --------- --------- --------- Income before income taxes $ 182,876 $ 223,938 $ 208,755 Provision for income taxes 60,615 71,545 65,649 --------- --------- --------- NET INCOME $ 122,261 $ 152,393 $ 143,106 ========= ========= ========= Net income per share $ 1.71 $ 2.12 $ 1.95 ========= ========= ========= Weighted average shares outstanding 71,342 71,954 73,487 ========= ========= ========= See accompanying notes to consolidated financial statements
68 INCORPORATED BY REFERENCE, PAGE 33 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS
ERIE INDEMNITY COMPANY CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY Years Ended December 31, 2001, 2000 and 1999 (Amounts in thousands, except per share data) Accumulated Total Other Shareholders' Comprehensive Retained Comprehensive Equity Income Earnings Income -------------- ------------- ------------ --------------- Balance, January 1, 1999 $ 655,223 $ 605,045 $ 40,178 Comprehensive income Net income 143,106 143,106 143,106 Unrealized depreciation of investments, net of tax ( 13,597) ( 13,597) ( 13,597) ----------- Comprehensive income $ 129,509 =========== Purchase of treasury stock ( 54,330) Dividends declared: Class A $.495 per share ( 32,575) ( 32,575) Class B $74.25 per share ( 228) ( 228) ----------- ----------- ----------- Balance, December 31, 1999 $ 697,599 $ 715,348 $ 26,581 ----------- ----------- ----------- Comprehensive income Net income 152,393 152,393 152,393 Unrealized depreciation of investments, net of tax ( 3,399) ( 3,399) ( 3,399) ----------- Comprehensive income $ 148,994 =========== Purchase of treasury stock ( 31,389) Dividends declared: Class A $.5575 per share ( 35,932) ( 35,932) Class B $83.625 per share ( 257) ( 257) ----------- ----------- ----------- Balance, December 31, 2000 $ 779,015 $ 831,552 $ 23,182 ----------- ----------- ----------- Comprehensive income Net income 122,261 122,261 122,261 Unrealized appreciation of investments, net of tax 14,890 14,890 14,890 Minimum pension liability adjustment, net of tax ( 2,850) ( 2,850) ( 2,850) ---------- Comprehensive income $ 134,301 ============ Purchase of treasury stock ( 7,654) Dividends declared: Class A $.6275 per share ( 40,119) ( 40,119) Class B $94.125 per share ( 288) ( 288) ----------- ----------- ----------- Balance, December 31, 2001 $ 865,255 $ 913,406 $ 35,222 =========== =========== =========== See accompanying notes to consolidated financial statements
69 INCORPORATED BY REFERENCE, PAGE 33 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS
ERIE INDEMNITY COMPANY CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (CONTINUED) Years Ended December 31, 2001, 2000 and 1999 (Amounts in thousands, except per share data) Class A Class B Additional Treasury Common Common Paid-in-Capital Stock ----------- --------- --------------- ------------ Balance, January 1, 1999 $ 1,955 $ 215 $ 7,830 $ 0 Comprehensive income Net income Unrealized depreciation of investments, net of tax Comprehensive income Purchase of treasury stock ( 54,330) Dividends declared: Class A $.495 per share Class B $74.25 per share ----------- Balance, December 31, 1999 $ 1,955 $ 215 $ 7,830 ($ 54,330) ----------- ---------- ----------- ----------- Comprehensive income Net income Unrealized depreciation of investments, net of tax Comprehensive income Purchase of treasury stock ( 31,389) Dividends declared: Class A $.5575 per share Class B $83.625 per share ----------- Balance, December 31, 2000 $ 1,955 $ 215 $ 7,830 ($ 85,719) ----------- ---------- ----------- ----------- Comprehensive income Net income Unrealized appreciation of investments, net of tax Minimum pension liability adjustment, net of tax Comprehensive income Purchase of treasury stock ( 7,654) Dividends declared: Class A $.6275 per share Class B $94.125 per share ----------- Balance, December 31, 2001 $ 1,955 $ 215 $ 7,830 ($ 93,373) =========== ========== =========== =========== See accompanying notes to consolidated financial statements
70 INCORPORATED BY REFERENCE, PAGE 32 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS
ERIE INDEMNITY COMPANY CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31, 2001, 2000 and 1999 (Dollars in thousands) 2001 2000 1999 ---------- ---------- ---------- CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 122,261 $ 152,393 $ 143,106 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 2,350 2,745 1,766 Deferred income tax expense (benefit) 1,013 ( 2,112) ( 1,311) Amortization of deferred policy acquisition costs 24,276 22,793 22,507 Realized loss (gain) on investments 31,879 ( 16,968) ( 14,746) Equity in losses (income) from limited partnerships 7 ( 4,733) ( 641) Net amortization of bond (discount) premium ( 199) ( 43) 80 Undistributed earnings of Erie Family Life 0 ( 4,020) ( 3,696) Dividends received in excess of undistributed earnings - Erie Family Life 821 0 0 Deferred compensation 294 642 1,212 Increase in accrued investment income ( 51) ( 1,089) ( 745) Increase in receivables ( 138,213) ( 76,240) ( 6,274) Policy acquisition costs deferred ( 28,092) ( 24,591) ( 23,049) Increase in prepaid expenses and other assets ( 14,460) ( 939) ( 6,185) Increase in accounts payable and accrued expenses 16,362 8,068 3,343 Increase in commissions payable and accrued 13,298 3,950 7,868 Increase in income taxes recoverable ( 10,452) ( 629) ( 466) Increase in loss reserves 79,398 44,984 6,730 Increase in unearned premiums 48,115 26,403 7,469 ---------- ---------- ---------- Net cash provided by operating activities $ 148,607 $ 130,614 $ 136,968 ---------- ---------- ---------- CASH FLOWS FROM INVESTING ACTIVITIES Purchase of investments: Fixed maturities ($ 235,854) ($ 153,029) ($ 162,769) Equity securities ( 67,549) ( 54,649) ( 71,637) Mortgage loans 0 0 ( 66) Limited partnership investments ( 28,380) ( 24,753) ( 20,667) Sales/maturities of investments: Fixed maturity sales 109,634 61,333 30,927 Fixed maturity calls/maturities 80,223 59,570 64,094 Equity securities 90,589 55,596 84,187 Mortgage loans 882 1,649 123 Limited partnership sales or distributions 6,634 6,227 1,368 Purchase of property and equipment ( 2,014) ( 308) ( 444) Purchase of computer software ( 1,113) ( 1,032) ( 4,194) Loans to agents ( 7,612) ( 1,781) ( 3,459) Collections on agent loans 2,358 1,719 2,582 ---------- ---------- ----------- Net cash used in investing activities ($ 52,202) ($ 49,458) ($ 79,955) ---------- ---------- ---------- CASH FLOWS FROM FINANCING ACTIVITIES Dividends paid to shareholders ($ 39,316) ($ 35,203) ($ 32,049) Purchase of treasury stock ( 7,654) ( 31,389) ( 54,330) ---------- ---------- ---------- Net cash used in financing activities ($ 46,970) ($ 66,592) ($ 86,379) ---------- ---------- ---------- Net increase (decrease) in cash and cash equivalents $ 49,435 $ 14,564 ($ 29,366) Cash and cash equivalents at beginning of year 38,778 24,214 53,580 ---------- ---------- ---------- Cash and cash equivalents at end of year $ 88,213 $ 38,778 $ 24,214 ========== ========== ========== SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid during the years ended December 31, 2001, 2000 and 1999 for income taxes was $70,751, $74,286 and $67,495, respectively. See accompanying notes to consolidated financial statements
71 INCORPORATED BY REFERENCE, PAGE 34 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS ERIE INDEMNITY COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS All dollar amounts are in thousands except per share data NOTE 1. NATURE OF BUSINESS Erie Indemnity Company (Company), formed in 1925, is the attorney-in-fact for the Erie Insurance Exchange (Exchange), a reciprocal insurance exchange. The Company earns a management fee for management services provided to the Exchange and its affiliates. The Exchange is a Pennsylvania domiciled property/casualty insurer rated A++ Superior by A. M. Best. The Exchange is the 23rd largest insurer in the United States based on net premiums written for all lines of business. See also Note 10. The Company's property/casualty insurance subsidiaries also share proportionately in the results of all property/casualty insurance underwriting operations of the Exchange. The Exchange, Erie Insurance Company (EIC), a wholly-owned subsidiary of the Company, and the Erie Insurance Company of New York (EINY), a wholly-owned subsidiary of the EIC, are part of an intercompany pooling agreement. Under this agreement, EIC and EINY cede 100% of their property/casualty insurance business, including property/casualty insurance operations assets and liabilities, to the Exchange. Erie Insurance Property & Casualty Company, a wholly-owned subsidiary of the Company, and Flagship City Insurance Company, owned by the Exchange, participate in a quota share agreement, where all insurance business is ceded to the Exchange. The Exchange retrocedes to EIC and EINY a specified percentage (5% for EIC and .5% for EINY during 2001, 2000 and 1999) of all pooled property/casualty insurance business, including insurance operations assets and liabilities. Insurance ceded by EIC, EINY, Erie Insurance Property & Casualty Company and Flagship City Insurance Company, to the Exchange does not relieve EIC and EINY from their primary liability as the original insurers. See also Note 12. The Exchange, EIC and EINY together with the Erie Insurance Property & Casualty Company and the Flagship City Insurance Company as well as the Erie Family Life Insurance Company (EFL) operate collectively as the "Erie Insurance Group (EIG)." The property/casualty insurers of the Erie Insurance Group operate in 11 states and the District of Columbia. Business consists, to a large extent, of private passenger and commercial automobile, homeowners and workers' compensation insurance in Pennsylvania, Ohio, West Virginia, Maryland and Virginia. NOTE 2. SIGNIFICANT ACCOUNTING POLICIES Basis of presentation The accompanying consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America that differ from statutory accounting practices prescribed or permitted for insurance companies by regulatory authorities. See also Note 13. Principles of consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. The 21.6% equity ownership of EFL is not consolidated but accounted for under the equity method of accounting. Reclassifications Certain amounts reported in prior years have been reclassified to conform to the current year's financial statement presentation. 72 INCORPORATED BY REFERENCE, PAGES 34 AND 35 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS ERIE INDEMNITY COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Use of estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Investments and cash equivalents Fixed maturities and marketable equity securities are classified as available-for-sale. Equity securities consist primarily of common and nonredeemable preferred stocks while fixed maturities consist of bonds, notes and redeemable preferred stock. Available-for-sale securities are stated at fair value, with the unrealized gains and losses, net of deferred tax, reflected in shareholders' equity in accumulated other comprehensive income. There are no securities classified as "trading" or "held-to-maturity." Realized gains and losses on sales of investments, are recognized in income on the specific identification method. Interest and dividend income is recorded as earned. Limited partnerships include U.S. and foreign private equity, real estate and fixed income investments. The private equity limited partnerships invest primarily in small- to medium-sized companies. Limited partnerships are recorded using the equity method, which approximates the Company's share of the carrying value of the partnership. Unrealized gains and losses on private equity limited partnerships are reflected in shareholders' equity in accumulated other comprehensive income, net of deferred taxes. The Company has not guaranteed any of the partnership liabilities. When a decline in value of investments is considered to be other-than-temporary by Company management, the investments are written down to realizable value. The write down is made on an individual security or limited partnership basis and is considered a realized loss in the Consolidated Statements of Operations. Mortgage loans on commercial real estate are recorded at unpaid balances, adjusted for amortization of premium or discount. A valuation allowance would be provided for impairment in net realizable value based on periodic valuations as needed. Cash equivalents are principally comprised of investments in bank money market funds and approximate fair value. Derivatives Financial Accounting Standards Board Statement of Financial Accounting Standards (FAS) No. 133, "Accounting for Derivative Instruments and Hedging Activities" (FAS 133) became effective for fiscal years beginning after June 15, 1999. Sections of FAS 133 were subsequently amended by FAS 138 "Accounting for Certain Derivative Instruments and Certain Hedging Activities" (an amendment of FAS 133 which became effective for all fiscal quarters of all fiscal years beginning after June 15, 2000). FAS 133 and FAS 138 establish accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. The accounting for changes in the fair value of a derivative, i.e. gains and losses, depends on the intended use of the derivative and the resulting designation. 73 INCORPORATED BY REFERENCE, PAGE 35 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS ERIE INDEMNITY COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) For derivatives not designated as a hedging instrument, the gain or loss is recognized in earnings in the period of change. Credit risk is managed by entering into transactions using a bank counterparty with a high credit rating. See also Note 3. Fair value of financial instruments Fair values of available-for-sale securities are based on quoted market prices, where available, or dealer quotations. The carrying amounts reported in the Consolidated Statements of Financial Position approximate fair value. The carrying value of receivables and liabilities arising in the ordinary course of business approximates fair value. Deferred policy acquisition costs Commissions and other costs of acquiring insurance that vary with, and are primarily related to, the production of new and renewal business are deferred and amortized over the terms of the policies or reinsurance treaties to which they relate. The amount of costs to be deferred would be reduced to the extent future policy premiums and anticipated investment income would not exceed related losses, expenses and Policyholder dividends. There have been no reduction in costs deferred in any of the years presented. Amortization expense, which is included in policy acquisition and other underwriting expenses of insurance underwriting operations, equaled $24,276, $22,793 and $22,507 in 2001, 2000 and 1999, respectively. Insurance liabilities Losses incurred refer to amounts paid or expected to be paid for loss events which have occurred through the balance sheet date. The cost of investigating, resolving and processing claims are referred to as "loss adjustment expenses". A liability is established for the total unpaid cost of losses and loss adjustment expenses, including events occurring in current and prior years. Losses are reported on the Consolidated Statements of Operations in insurance underwriting operations. The liability for losses and loss adjustment expenses includes an amount determined from loss reports and individual cases and an amount, based on past experience, for losses incurred but not reported. Inflation is provided for in the reserving function through analysis of costs, trends and reviews of historical reserving results. Such liabilities are necessarily based on estimates and, while management believes the amount is appropriate, the ultimate liability may differ from the amounts provided. The methods for making such estimates and for establishing the resulting liability are continually reviewed, and any adjustments considered necessary are reflected in current earnings. Loss reserves, as permitted by insurance department statute, are set at full expected cost except for loss reserves for workers' compensation which have been discounted at 2.5% in 2001 and 2000. Unpaid losses and loss adjustment expenses in the Consolidated Statements of Financial Position were reduced by $2,390 and $1,509 at December 31, 2001 and 2000, respectively, due to discounting. The reserves for losses and loss adjustment expenses are reported net of receivables for salvage and subrogation of $3,661 and $3,349 at December 31, 2001 and 2000, respectively. 74 INCORPORATED BY REFERENCE, PAGES 35 AND 36 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS ERIE INDEMNITY COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Environment-related claims In establishing the liability for unpaid losses and loss adjustment expenses related to environmental claims, management considers facts currently known and the current state of the law and coverage litigation. Liabilities are recognized for known claims (including the cost of related litigation) when sufficient information has been developed to indicate the involvement of a specific insurance policy, and management can reasonably estimate its liability. In addition, liabilities have been established to cover additional exposures on both known and unasserted claims. Estimates of the liabilities are reviewed and updated continually. The total amount of the Company's property/casualty insurance subsidiaries' share of paid losses and loss reserves pertaining to environment-related claims is immaterial. Liability for guaranty fund and other assessments The Company's property/casualty insurance subsidiaries may be required, under the solvency or guaranty laws of the various states in which they are licensed, to pay assessments up to prescribed limits to fund Policyholder losses or liabilities of insolvent insurance companies. The liability for guaranty fund or other assessments is recorded when the event obligating the Company has occurred and the amount can be reasonably estimated. The estimated liability for guaranty fund and other assessments at December 31, 2001 and 2000 totaled $2,383 and $592, respectively. During 2001, the Company received notification of the insolvency of Reliance Insurance Company. It is expected this insolvency will result in guaranty fund liabilities to be assessed the Company's property/casualty insurance subsidiaries. The Company has recorded an estimated liability that has been charged to operations in the current period based on preliminary data relating to this insolvency. The estimated liability for the Reliance insolvency is $2,024 at December 31, 2001. Certain states permit these assessments, or a portion thereof, to be recovered as an offset to future premium taxes. When an assessment can be recovered, an asset is established on a basis consistent with the credits to be realized under applicable state law. During 2001, the Company's property/casualty insurance subsidiaries recorded an asset of $559 related to these recoverable credits which will be recovered in accordance with state law which ranges between a 5 and 10 year period. These liabilities and corresponding recoverable assets are presented gross on the Consolidated Statement of Financial Position. Reinsurance The insurance underwriting operations segment in the Consolidated Statements of Operations is presented net of reinsurance activities. Gross losses and expenses incurred are reduced for amounts expected to be recovered under reinsurance agreements. Reinsurance transactions are recorded gross on the Consolidated Statements of Financial Position. Estimated reinsurance recoverables and receivables for ceded unearned premiums are recorded as assets with liabilities recorded for related unpaid losses and expenses and unearned premiums. Reinsurance premiums are recognized as revenue on a pro rata basis over the policy term. 75 INCORPORATED BY REFERENCE, PAGE 36 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS ERIE INDEMNITY COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Income taxes Provisions for income taxes include deferred taxes resulting from changes in cumulative temporary differences between the tax bases and financial statement bases of assets and liabilities. Deferred taxes are provided on the liability method, whereby deferred tax assets are recognized for deductible temporary differences and deferred tax liabilities are recognized for taxable temporary differences. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. Property and equipment Property and equipment are stated at cost. Improvements and replacements are capitalized, while expenditures for maintenance and repairs are charged to expense as incurred. Depreciation of property and equipment is computed using straight line and accelerated methods over the estimated useful lives of the assets. The costs and accumulated depreciation and amortization of property sold or retired are removed from the accounts and gains or losses, if any, are reflected in earnings for the year. Property and equipment as of December 31 is summarized as follows: 2001 2000 --------- --------- Land $ 737 $ 737 Buildings 5,879 5,863 Leasehold improvements 518 322 Computer software 18,836 17,723 Computer equipment 5,416 3,706 Transportation equipment 544 450 --------- --------- $ 31,930 $ 28,801 Less accumulated depreciation 17,295 14,945 --------- --------- $ 14,635 $ 13,856 ========= ========= Software development costs, primarily salaries and benefits, totaling $7,842 and $7,797, are included in property and equipment at December 31, 2001 and 2000, respectively. Software development costs capitalized during 2001 and 2000 amounted to $45 and $499, respectively. These costs are amortized on a straight-line basis over the expected life of the applications once the software is ready for intended use. Software amortization related to these costs totaled $2,007, $1,697 and $199 in 2001, 2000 and 1999, respectively. During 2001, the Company entered into various operating lease agreements for computer equipment. These leases contain various early termination provisions which allow the Company to cancel the leases generally after three years from inception of the lease. The total projected commitment for these leases at December 31, 2001, approximates $10,051 through the year 2004. Of this total, approximately $5,075 will be reimbursed to the Company from its affiliates. The total rental expense for 2001 was $165. 76 INCORPORATED BY REFERENCE, PAGE 36 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS ERIE INDEMNITY COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Revenue recognition In 2000, the Securities and Exchange Commission issued Staff Accounting Bulletin (SAB) No. 101, "Revenue Recognition in Financial Statements." SAB 101 states revenue should not be recognized until it is realized or realizable and earned. Cited in SAB 101 are certain criteria that generally should be met to determine when revenue is realized or realizable and earned. The Company periodically evaluates its revenue recognition practices in relation to the requirements of SAB 101. Management believes the revenue recognition practices are in compliance with the provisions of SAB 101. Recognition of management fee revenue A management fee is charged the Exchange by the Company for management of the affairs of the Exchange. The fee is recorded as revenue, calculated as a percentage of Exchange direct and affiliated assumed premiums written. The management fees are recognized upon policy issuance or renewal. The Exchange issues policies with annual terms only. Recognition of premium revenues and losses Property and liability premiums are generally recognized as revenue on a pro rata basis over the policy term. Unearned premiums represent the unexpired portion of premiums written. Losses and loss adjustment expenses are recorded as incurred. Premiums earned and losses and loss adjustment expenses incurred are reflected in the Consolidated Statements of Operations net of amounts ceded to the Exchange. See also Note 12. Earnings per share Earnings per share is based on the weighted average number of Class A shares outstanding, giving effect to the conversion of the weighted average number of Class B shares outstanding at a rate of 2,400 Class A shares for one Class B share. The total weighted average number of Class A equivalent shares outstanding (including conversion of Class B shares) was 71,342,329, 71,954,402, and 73,486,572 during 2001, 2000 and 1999, respectively. 77 INCORPORATED BY REFERENCE, PAGE 37 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS ERIE INDEMNITY COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 3. INVESTMENTS The following tables summarize the cost and market value of available-for-sale securities at December 31, 2001 and 2000:
Gross Gross Estimated Amortized Unrealized Unrealized Fair Cost Gains Losses Value ----------- ----------- ----------- ------------ December 31, 2001 Fixed Maturities: ----------------- U.S. treasuries & government agencies $ 11,211 $ 502 $ 0 $ 11,713 States & political subdivisions 42,392 1,817 88 44,121 Special revenue 110,267 3,496 345 113,418 Public utilities 25,150 1,156 36 26,270 U. S. industrial & miscellaneous 311,757 8,989 1,438 319,308 Foreign 26,634 859 17 27,476 ----------- ----------- ----------- ----------- Total bonds $ 527,411 $ 16,819 $ 1,924 $ 542,306 Redeemable preferred stock 16,012 1,555 0 17,567 ----------- ----------- ----------- ----------- Total fixed maturities $ 543,423 $ 18,374 $ 1,924 $ 559,873 ----------- ----------- ----------- ----------- Equity Securities: ------------------ Common stock: U. S. banks, trusts & insurance companies $ 3,284 $ 814 $ 16 $ 4,082 U. S. industrial & miscellaneous 28,718 31,570 579 59,709 Nonredeemable preferred stock: Public Utilities 2,370 12 3 2,379 U. S. banks, trusts & insurance companies 14,685 938 58 15,565 U. S. industrial & miscellaneous 91,185 2,573 2,111 91,647 Foreign 19,485 1,039 108 20,416 ----------- ----------- ----------- ----------- Total equity securities $ 159,727 $ 36,946 $ 2,875 $ 193,798 ----------- ----------- ----------- ----------- Total available-for-sale securities $ 703,150 $ 55,320 $ 4,799 $ 753,671 =========== =========== =========== ===========
78 INCORPORATED BY REFERENCE, PAGE 37 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS ERIE INDEMNITY COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 3. INVESTMENTS (CONTINUED)
Gross Gross Estimated Amortized Unrealized Unrealized Fair Cost Gains Losses Value ----------- ----------- ----------- ------------ December 31, 2000 Fixed Maturities: ----------------- U.S. treasuries & government agencies $ 11,216 $ 420 $ 24 $ 11,612 States & political subdivisions 50,337 1,656 34 51,959 Special revenue 110,855 3,779 68 114,566 Public utilities 23,221 550 207 23,564 U. S. industrial & miscellaneous 267,231 4,770 5,940 266,061 Foreign 30,082 238 406 29,914 ----------- ----------- ----------- ----------- Total bonds $ 492,942 $ 11,413 $ 6,679 $ 497,676 Redeemable preferred stock 31,230 3,341 701 33,870 ----------- ----------- ----------- ----------- Total fixed maturities $ 524,172 $ 14,754 $ 7,380 $ 531,546 ----------- ----------- ----------- ----------- Equity Securities: ------------------ Common stock: U. S. banks, trusts & insurance companies $ 3,651 $ 422 $ 275 $ 3,798 U. S. industrial & miscellaneous 63,662 38,286 15,343 86,605 Foreign 7,100 581 2,719 4,962 Nonredeemable preferred stock: U. S. banks, trusts & insurance companies 22,094 97 66 22,125 U. S. industrial & miscellaneous 62,266 1,987 3,119 61,134 Foreign 26,195 217 590 25,822 ----------- ----------- ----------- ----------- Total equity securities $ 184,968 $ 41,590 $ 22,112 $ 204,446 ----------- ----------- ----------- ----------- Total available-for-sale securities $ 709,140 $ 56,344 $ 29,492 $ 735,992 =========== =========== =========== ===========
79 INCORPORATED BY REFERENCE, PAGE 38 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS ERIE INDEMNITY COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 3. INVESTMENTS (CONTINUED) The amortized cost and estimated fair value of fixed maturities at December 31, 2001, by remaining contractual term to maturity, are shown below.
Amortized Estimated Cost Fair Value -------------- ----------- Due in one year or less $ 37,241 $ 37,787 Due after one year through five years 162,766 167,265 Due after five years through ten years 160,105 165,194 Due after ten years 183,311 189,627 ----------- ----------- $ 543,423 $ 559,873 =========== ===========
Changes in unrealized gains (losses) consist of the following for the years ended December 31:
2001 2000 1999 ------------ ------------ ------------ Equity securities $ 14,593 ($ 24,410) $ 11,061 Fixed maturities 9,076 11,246 ( 24,123) Limited partnerships ( 5,651) 5,930 1,616 Equity in unrealized gains (losses) of Erie Family Life Insurance Company 4,890 2,005 ( 9,473) Deferred federal income tax (liability) benefit ( 8,018) 1,830 7,322 ----------- ------------ ------------ Increase (decrease) in unrealized gains $ 14,890 ($ 3,399) ($ 13,597) ============ ============ ============
Sources of net investment income for the years ended December 31 are as follows:
2001 2000 1999 ------------ ------------ ------------ Fixed maturities $ 36,569 $ 34,445 $ 30,547 Equity securities 11,022 11,034 10,104 Cash equivalents and other 3,034 3,416 3,222 ------------ ------------ ------------ Total investment income $ 50,625 $ 48,895 $ 43,873 Investment expense 741 494 529 ------------ ------------ ------------ Net investment income $ 49,884 $ 48,401 $ 43,344 ============ ============ ============
80 INCORPORATED BY REFERENCE, PAGE 38 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS ERIE INDEMNITY COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 3. INVESTMENTS (CONTINUED) Following are the components of net realized (loss) gain on investments as reported on the Consolidated Statements of Operations. The securities impairment charge in 2001 related primarily to preferred stocks in the equipment leasing and agricultural industry segments. The limited partnership impairment charge resulted from one private equity partnership that had investments of preferred stock in the eCommerce industry and common stock in the customer relationship software industry. The securities impairment charge in 2000 resulted from preferred stocks in the financial services industry.
2001 2000 1999 ----------- ------------ ----------- Fixed maturities: ---------------- Gross realized gains $ 4,216 $ 2,921 $ 712 Gross realized losses ( 7,941) ( 311) ( 87) ------------- ------------ ------------ Net realized (losses) gains ($ 3,725) $ 2,610 $ 625 ------------- ------------ ------------ Equity securities: ----------------- Gross realized gains $ 4,997 $ 18,070 $ 18,437 Gross realized losses ( 28,563) ( 2,445) ( 4,316) Impairment charge ( 1,855) ( 1,267) 0 ------------ ------------ ------------ Net realized (losses) gains ($ 25,421) $ 14,358 $ 14,121 ------------ ------------ ------------ Limited partnership impairment charge ($ 2,733) $ 0 $ 0 ------------ ------------ ------------ Net realized (losses) gains on investments ($ 31,879) $ 16,968 $ 14,746 ============ ============ ============
The components of equity in (losses) earnings of limited partnerships as reported on the Consolidated Statements of Operations for the years ended December 31 are as follows:
2001 2000 1999 ------------ ------------ ------------- Private equity ($ 2,013) $ 1,464 ($ 354) Real estate 1,424 1,926 905 Fixed income 582 1,343 90 ------------ ------------ ------------ Total equity in (losses) earnings of limited partnerships ($ 7) $ 4,733 $ 641 ============ ============ ============
See also Note 14 for investment commitments related to partnerships. The Company participates in a securities lending program whereby certain securities from its portfolio are loaned to other institutions for short periods of time through a lending agent. The Company maintains control over the securities. A fee is paid to the Company by the borrower. Collateral, comprised of cash and government securities, that exceeds the market value of the loaned securities is maintained by the lending agent. The Company has an indemnification agreement with the lending agent in the event a borrower becomes insolvent or fails to return securities. The Company had loaned securities with a market value of $46,771 and $31,776 and secured collateral of $48,804 and $33,468 at December 31, 2001 and 2000, respectively. The borrower of the securities is not permitted to sell or replace the security on loan. The Company maintains the loaned securities on its Consolidated Statements of Financial Position as part of its invested assets. The Company has incurred no losses on the loan program since the program's inception. 81 INCORPORATED BY REFERENCE, PAGE 39 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS ERIE INDEMNITY COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 3. INVESTMENTS (CONTINUED) During 2001, the Company entered into several foreign currency forward contracts related to its limited partnership investments, which are by definition derivatives. These contracts were not designated as hedges as the primary purpose is to generate profits from short-term market movements. The forward contracts have no cash requirements at the inception of the arrangement. At December 31, 2001, the notional amount of the contracts outstanding totaled $1,869. Changes in value, totaling $8 in 2001, have been recognized currently in earnings as realized gains in the Consolidated Statements of Operations. NOTE 4. COMPREHENSIVE INCOME Comprehensive income is defined as any change in equity from transactions and other events originating from nonowner sources. The components of other comprehensive income follow for the years ended December 31:
2001 2000 1999 ------------- ------------- ------------- Unrealized holding (losses) gains on securities arising during period ($ 8,971) $ 11,739 ($ 6,173) Less: losses (gains) included in net income 31,879 ( 16,968) ( 14,746) ------------ ------------ ------------ Net unrealized holding gains (losses) arising during period 22,908 ( 5,229) ( 20,919) Income tax (liability) benefit related to unrealized gains or losses ( 8,018) 1,830 7,322 ------------ ------------ ------------ Net appreciation (depreciation) of investments 14,890 ( 3,399) ( 13,597) Minimum pension liability adjustment (See also Note 6) ( 4,384) 0 0 Tax asset related to pension liability adjustment 1,534 0 0 ------------ ------------ ------------ Net pension liability adjustment ( 2,850) 0 0 ------------ ------------ ------------ Other comprehensive income (loss), net of tax $ 12,040 ($ 3,399) ($ 13,597) ============ ============ ============
NOTE 5. EQUITY IN ERIE FAMILY LIFE INSURANCE COMPANY The Company owns 21.6% of EFL's common shares outstanding, which is accounted for using the equity method of accounting. EFL is a Pennsylvania-domiciled life insurance company operating in ten states and the District of Columbia. 82 INCORPORATED BY REFERENCE, PAGES 39 AND 40 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS ERIE INDEMNITY COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 5. EQUITY IN ERIE FAMILY LIFE INSURANCE COMPANY (CONTINUED) The following represents condensed financial information for EFL on a Generally Accepted Accounting Principles (GAAP) basis:
2001 2000 1999 ----------- ----------- ------------ Investments $ 869,723 $ 881,069 $ 817,460 Total assets 1,120,483 1,020,343 954,532 Liabilities 914,724 824,623 783,429 Shareholders' equity 205,759 195,720 171,103 Revenues 89,514 115,373 102,924 Net income 2,738 25,390 23,325 Comprehensive income (loss) 17,410 31,421 ( 5,191) Dividends paid to shareholders 7,229 6,662 6,096
The Company's share of EFL's net unrealized gains or (losses) on securities, as reflected in shareholders' equity, is $3,983, $801 and ($502) at December 31, 2001, 2000 and 1999, respectively. NOTE 6. BENEFIT PLANS Pension plans The Company's pension plans consist of: (1) a noncontributory-defined benefit pension plan covering substantially all Employees of the Company, (2) an unfunded supplemental employee retirement plan (SERP) for its senior and executive officers and (3) an unfunded pension plan for its outside directors. Information about the plans follows for the years ended December 31:
2001 2000 ---------- ---------- Net periodic benefit cost: Service cost $ 6,837 $ 6,329 Interest cost 8,325 7,705 Expected return on plan assets ( 13,709) ( 12,322) Amortization of prior service cost 844 989 Recognized net actuarial gain ( 2,583) ( 2,303) Amortization of unrecognized initial net asset ( 234) ( 234) ---------- ---------- Net periodic benefit cost $ 520 $ 164 ========== ==========
83 INCORPORATED BY REFERENCE, PAGE 40 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS ERIE INDEMNITY COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 6. BENEFIT PLANS (CONTINUED)
2001 2000 ---------- ---------- Change in benefit obligation: Benefit obligation at January 1 $ 116,693 $ 104,588 Service cost 6,837 6,329 Interest cost 8,325 7,705 Amendments 55 611 Actuarial loss (gain) 14,523 ( 2,114) Benefits paid ( 1,729) ( 426) ---------- ---------- Benefit obligation at December 31 $ 144,704 $ 116,693 ========== ========== Change in plan assets: Fair value of plan assets at January 1 $ 171,636 $ 160,385 Actual return on plan assets ( 31,413) 11,688 Employer contributions (refunds) 9,271 ( 11) Benefits paid ( 1,729) ( 426) ---------- ---------- Fair value of plan assets at December 31 $ 147,765 $ 171,636 ========== ========== Reconciliation of funded status: Funded status at December 31 $ 3,061 $ 54,943 Unrecognized net actuarial loss (gain) 10,986 ( 51,342) Unrecognized prior service cost 5,236 6,025 Unrecognized initial net asset ( 469) ( 701) ---------- ---------- Net amount recognized on Consolidated Statements of Financial Position $ 18,814 $ 8,925 ========== ========== Amounts recognized in the consolidated statements of financial position consist of: Prepaid benefit cost $ 25,451 $ 15,096 Accrued benefit liability ( 13,686) ( 8,656) Intangible asset 2,665 2,485 Accumulated other comprehensive income 4,384 0 ----------- ----------- Net amount recognized at year end $ 18,814 $ 8,925 ========== ========== Weighted-average assumptions as of December 31: Employee pension plan: Discount rate 7.00% 7.50% Expected return on plan assets 8.25 8.25 Rate of compensation increase 5.00 5.00 SERP: Discount rate 7.00% 7.50% Rate of compensation increase 6.00-7.25 5.00
The amendment amounts relate primarily to two additional participants being added to the SERP for each of the years 2001 and 2000. The Employee pension plan has assets that include cash, treasury bonds, corporate bonds, common and preferred stocks and mortgages. 84 INCORPORATED BY REFERENCE, PAGES 40 AND 41 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS ERIE INDEMNITY COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 6. BENEFIT PLANS (CONTINUED) An additional minimum pension liability of $4,384 resulted in 2001 due to changes in discount rates, the rate of compensation increase and certain other assumptions of the SERP. The additional pension liability was recorded as a reduction to shareholders' equity as accumulated other comprehensive income, net of deferred income taxes. The Company's funding policy regarding the Employee pension plan is to contribute amounts sufficient to meet ERISA funding requirements plus such additional amounts as may be determined to be appropriate. The Employee pension plan purchases individual annuities periodically from EFL to settle retiree benefit payments. Such purchases equaled $4,513, $5,627 and $5,322 in 2001, 2000 and 1999, respectively. These are non-participating annuity contracts under which EFL has unconditionally contracted to provide specified benefits to beneficiaries in return for a fixed premium from the plan. However, the plan remains the primary obligor to the beneficiaries and a contingent liability exists in the event EFL could not honor the annuity contracts. The benefit obligation has been reduced for these annuities purchased for retirees. The projected benefit obligation, accumulated benefit obligation, and fair value of plan assets for the pension plans with accumulated benefit obligations in excess of plan assets (SERP and the pension plan for outside directors) were $20,348, $13,686 and $0 respectively, as of December 31, 2001, and $12,696, $8,656 and $0, respectively, as of December 31, 2000. Post-retirement benefits other than pensions The Company provides post-retirement medical coverage for eligible retired Employees and eligible dependents. To be eligible for benefits, an employee must be 60 years old and have 15 years of continuous full-time service. The benefits are provided from retirement to age 65. The benefits are unfunded as the Company pays the obligations when due. The cash payments for such benefits were $379, $161 and $121 in 2001, 2000 and 1999, respectively. Actuarially determined costs are recognized over the period the Employee provides service to the Company. Information about this plan follows for the years ended December 31:
2001 2000 --------- --------- Net periodic benefit cost: Service cost $ 400 $ 400 Interest cost 389 385 Amortization of prior service cost ( 36) ( 37) Recognized net actuarial gain ( 50) ( 27) -------- -------- Net periodic benefit cost $ 703 $ 721 ======== ======== Change in benefit obligation: Benefit obligation at January 1 $ 5,803 $ 4,745 Service cost 400 400 Interest cost 389 385 Actuarial loss 919 434 Benefits paid ( 379) ( 161) -------- -------- Benefit obligation at December 31 $ 7,132 $ 5,803 ======== ======== Reconciliation of Funded status: Funded status at December 31 ($ 7,132) ($ 5,803) Unrecognized net actuarial loss (gain) 244 ( 726) Unrecognized prior service costs ( 330) ( 366) -------- -------- Net liability recognized on Consolidated Statements of Financial Position ($ 7,218) ($ 6,895) ======== ========
85 INCORPORATED BY REFERENCE, PAGE 41 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS ERIE INDEMNITY COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 6. BENEFIT PLANS (CONTINUED) The weighted average discount rate used to measure the accumulated post-retirement benefit obligation was 7.0% and 7.50% in 2001 and 2000, respectively. The December 31, 2001, accumulated benefit obligation was based on a 10.0% increase in the cost of covered health care benefits during 2001. The expected health care cost trend rate assumption for 2002 is 10.0%. This rate is assumed to decrease gradually to 5.5% per year in 2006 and to remain at that level thereafter.
2001 2000 --------- ---------- Effect on total of service and interest cost components: 1% Increase $ 126 $ 126 1% Decrease ( 106) ( 106) Effect on post-retirement benefit obligation: 1% Increase $ 1,023 $ 814 1% Decrease ( 871) ( 695)
Employee savings plan The Company has an Employee Savings Plan for its Employees. Beginning January 2001, the maximum percentage that eligible participants were permitted to contribute to the plan was increased to 15%. The Company match was also changed to 100% of the participant contributions up to 3% of compensation and 50% of participant contributions over 3% and up to 5% of compensation. Additionally, regular part-time Employees are eligible to participate in the plan. Prior to 2001, eligible participants were permitted to make contributions of 1% to 8% of compensation to the plan on a pre-tax salary reduction basis. The Company matched one-half of the participant contributions up to 6% of compensation. All full-time Employees were eligible to participate in the plan. The Company's matching contributions to the plan in 2001, 2000 and 1999 were $5,329, $3,499 and $3,245, respectively. Employees are permitted to invest a portion of employer contributions in the Class A common stock of the Company. The plan acquires shares in the open market necessary to meet the obligations of the plan. 86 INCORPORATED BY REFERENCE, PAGES 41 AND 42 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS ERIE INDEMNITY COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 6. BENEFIT PLANS (CONTINUED) Management incentive plans and deferred compensation The Company has separate annual and long-term incentive plans and a deferred compensation plan, which are available for key management employees. The deferred compensation plan is an unfunded arrangement for a select group of management and highly compensated employees of the Company. Those participating in this plan can select hypothetical investment funds for their deferrals and are credited with interest based on the investment results. The incentive plans are available to key management employees and link awards to current year and three-year performance period targets. The awards are settled with cash and Company stock. The Company purchases its stock in the open market when awards are settled in stock. The Company accrues estimated compensation expense in the applicable performance period based on its best estimate of the achievement of the performance targets. Expense recorded in 2001, 2000 and 1999 relating to these incentive and deferred compensation plans equaled $3,424, $3,445 and $3,352, respectively. Actual payments totaled $2,441 and $1,590 in 2001 and 2000, respectively. There were no payments in 1999. The Company also has a deferred compensation plan for certain of its outside directors. Expenses recorded in 2001, 2000, and 1999 with related (losses) earnings amounted to ($70), $78 and $241, respectively. The losses in the current year were a result of the performance of the investments that comprise the plan assets. Health and dental benefits The Company has self-funded health and dental care plans for all of its Employees and eligible dependents. Estimated unpaid claims incurred are accrued as a liability at December 31, 2001 and 2000. Operations were charged $19,826, $17,456 and $14,756 in 2001, 2000 and 1999, respectively, for the cost of health and dental care provided under these plans. All liabilities for the above mentioned plans are presented in this note in total for all employees of the Erie Insurance Group. The gross liability is presented in the Consolidated Statements of Financial Position as employee benefit obligations with amounts expected to be recovered from the Company's affiliates included in other assets. NOTE 7. INCOME TAXES The provision for income taxes consists of the following for the years ended December 31:
2001 2000 1999 ---------- ---------- ---------- Federal income taxes: Currently due $ 59,602 $ 73,657 $ 66,960 Deferred 1,013 ( 2,112) ( 1,311) ---------- ---------- ---------- Total $ 60,615 $ 71,545 $ 65,649 ========== ========== ==========
A reconciliation of the provision for income taxes with amounts determined by applying the statutory federal income tax rates to pre-tax income is as follows:
2001 2000 1999 ----------- ----------- ------------ Income tax at statutory rates $ 64,007 $ 78,378 $ 73,051 Tax-exempt interest ( 2,729) ( 3,046) ( 3,229) Dividends received deduction ( 2,398) ( 2,160) ( 2,064) Other 1,735 ( 1,627) ( 2,109) ---------- ---------- ---------- Provision for income taxes $ 60,615 $ 71,545 $ 65,649 ========== ========== ==========
87 INCORPORATED BY REFERENCE, PAGE 42 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS ERIE INDEMNITY COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 7. INCOME TAXES (CONTINUED) Temporary differences and carryforwards, which give rise to deferred tax assets and liabilities, are as follows for the years ended December 31:
2001 2000 --------- --------- Deferred tax assets: Loss reserve discount $ 4,580 $ 3,965 Unearned premiums 4,960 4,286 Employee benefit plan obligations 4,800 4,111 Severance benefits 3,801 0 Write downs of securities 1,606 443 Other 1,525 1,212 --------- --------- Total deferred tax assets $ 21,272 $ 14,017 --------- --------- Deferred tax liabilities: Deferred policy acquisition costs $ 5,956 $ 4,621 Unrealized gains 16,822 12,051 Pension and other benefits 7,021 2,438 Other 4,418 2,068 --------- --------- Total deferred tax liabilities $ 34,217 $ 21,178 --------- --------- Net deferred income tax liability $ 12,945 $ 7,161 ========= =========
The Company, as a corporate attorney-in-fact for a reciprocal insurer, is not subject to state corporate taxes. NOTE 8. CAPITAL STOCK Class A and B shares Holders of Class B shares may, at their option, convert their shares into Class A shares at the rate of 2,400 Class A shares for each Class B share. There is no provision for conversion of Class A shares to Class B shares and Class B shares surrendered for conversion cannot be reissued. Each share of Class A common stock outstanding at the time of the declaration of any dividend upon shares of Class B common stock shall be entitled to a dividend payable at the same time, at the same record date, and in an amount at least equal to 2/3 of 1% of any dividend declared on each share of Class B common stock. The Company may declare and pay a dividend in respect of Class A common stock without any requirement that any dividend be declared and paid in respect of Class B common stock. Sole voting power is vested in Class B common stock except insofar as any applicable law shall permit Class A common stock to vote as a class in regards to any changes in the rights, preferences and privileges attaching to Class A common stock. 88 INCORPORATED BY REFERENCE, PAGES 42 AND 43 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS ERIE INDEMNITY COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 8. CAPITAL STOCK (CONTINUED) Stock repurchase plan Beginning in 1999, the Company established a stock repurchase program. The Company may repurchase as much as $120 million of its outstanding Class A common stock through December 31, 2002. Treasury shares are recorded on the Consolidated Statements of Financial Position at cost. In 2001 there were 220,000 shares repurchased at a total cost of $7,654, or an average price per share of $34.79. Since its inception, 3,195,677 shares have been repurchased at a total cost of $93,373, or an average price per share of $29.22. The Company may purchase the shares from time to time in the open market or through privately negotiated transactions, depending on prevailing market conditions and alternative uses of the Company's capital. NOTE 9. UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES The following table provides a reconciliation of beginning and ending loss and loss adjustment expense liability balances for the Company's wholly-owned property/casualty insurance subsidiaries:
2001 2000 1999 ---------- ---------- ----------- Total unpaid losses and loss adjustment expenses at January 1, gross $ 477,879 $ 432,895 $ 426,165 Less reinsurance recoverables 375,567 337,911 334,708 ---------- ---------- ---------- Net balance at January 1 102,312 94,984 91,457 Incurred related to: Current accident year 111,258 93,416 88,422 Prior accident years 5,943 6,148 ( 703) ---------- ---------- ---------- Total incurred 117,201 99,564 87,719 Paid related to: Current accident year 59,637 53,251 50,560 Prior accident years 41,203 38,985 33,632 ---------- ---------- ---------- Total paid 100,840 92,236 84,192 ---------- ---------- ---------- Net balance at December 31 118,673 102,312 94,984 Plus reinsurance recoverables 438,605 375,567 337,911 ---------- ---------- ---------- Total unpaid losses and loss adjustment expenses at December 31, gross $ 557,278 $ 477,879 $ 432,895 ========== ========== ==========
Included in the 2001 losses and loss adjustment expenses incurred related to current accident year of $111,258 are the Company's share of estimated incurred losses of the Erie Insurance Group's reinsurance business stemming from the September 11th attack on the World Trade Center of $8,250. Partially offsetting these losses is an aggregate excess of loss reinsurance agreement between the Exchange and the Company's property/casualty insurance subsidiaries. See also Note 12. This agreement reduces the net retention of these losses recorded by the Company to $5,839. Current loss estimates are based on the assumption that the attack will be considered one event. If the attack comes to 89 INCORPORATED BY REFERENCE, PAGE 43 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS ERIE INDEMNITY COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 9. UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES (CONTINUED) be considered two events, the total potential exposure for EIG would increase between $50,000 and $75,000. The effect on the Company would be additional losses between $2,750 and $4,125. Taking into consideration the excess of loss reinsurance agreement, the net impact of such potential additional losses would be minimal to the Company. The property/casualty insurers are exposed to both direct and reinsurance losses arising from possible future terrorist actions and other catastrophic events. The 2001 incurred losses related to prior accident years of $5,943 are due primarily to adverse development of losses in the private passenger auto liability and workers' compensation lines of business and are generally the result of ongoing analysis of recent loss development trends. These losses are reflected in the insurance underwriting operations segment of the Consolidated Statements of Operations. The 2000 incurred losses related to prior accident years of $6,148 are due to adverse development of reinsurance losses from the catastrophic storms in Europe in December 1999, combined with increased loss severity in private passenger automobile and in commercial lines of business. NOTE 10. RELATED PARTY TRANSACTIONS Management fee A management fee is charged to the Exchange for management services provided by the Company. The fee is a percentage of Exchange direct and affiliated assumed premiums written. The percentage rate is adjusted periodically within specified limits by the Company's Board of Directors. The management fee charged the Exchange was 25% for each year from 1999 to 2001. In December 2001, the Board of Directors elected to maintain the 25% management fee rate for all of 2002. The Company's Board of Directors may change the management fee rate at its discretion, but it may not exceed 25%. eCommerce Program and Related Information Technology Infrastructure During 2001, the Erie Insurance Group undertook a series of initiatives to develop its eCommerce capabilities. In connection with this program, the Company and the property/casualty insurance companies of the Erie Insurance Group entered into a Cost Sharing Agreement for Information Technology Development (Agreement). The Agreement describes how member companies of the Erie Insurance Group will share the costs to be incurred for the development of new Internet enabled property/casualty policy administration and customer relationship management systems. The Agreement provides that the cost of the systems and the related enabling technology costs, such as required infrastructure and architectural tools, will be shared among the property/casualty insurance companies in a manner consistent with the sharing of insurance transactions under the existing intercompany pooling agreement. See also Note 12. These costs are included in the policy acquisition and other underwriting expenses in the Consolidated Statements of Operations. The Company's share of these costs, incurred by the Company's property/casualty subsidiaries totaled $1,315 for the year ended December 31, 2001. Certain other costs of the eCommerce Program are related to information technology hardware and are not included under the Agreement. These costs are included in the cost of management operations in the Consolidated Statement of Operations. The Company's share of these infrastructure costs amounted to $1,589 for the year ended December 31, 2001. 90 INCORPORATED BY REFERENCE, PAGE 44 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS ERIE INDEMNITY COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 10. RELATED PARTY TRANSACTIONS (CONTINUED) Service agreement revenue A service agreement fee is charged to the Exchange to compensate the Company for its management of non-affiliated assumed reinsurance business on behalf of the Exchange. The Company receives a fee of 7% of voluntary reinsurance premiums assumed from non-affiliated insurers and is responsible for accounting, underwriting, and operating expenses in connection with the administration of this business. Service agreement fee revenue amounted to $11,251, $10,149 and $8,158 in 2001, 2000 and 1999, respectively. Also included in service agreement revenue are service charges collected from Policyholders for providing extended payment terms on policies written by the insurers managed by the Company. In June 2000, this administrative fee collected from Policyholders increased from $2 to $3 per installment for policies renewing in most states. Service charge revenue amounted to $15,996, $12,513 and $7,283 in 2001, 2000 and 1999, respectively. Expense reimbursements The Company pays for and is reimbursed by the Exchange for expenses incurred in connection with adjustment of claims and administrative services and by EFL for administrative expenses. Reimbursements are made to the Company from these affiliates monthly. The amounts of such expense reimbursements were as follows for the years ended December 31:
2001 2000 1999 ----------- ----------- ----------- Erie Insurance Exchange $ 162,549 $ 142,519 $ 136,045 Erie Family Life 18,545 18,631 14,740 ----------- ----------- ----------- Total reimbursements $ 181,094 $ 161,150 $ 150,785 =========== =========== ===========
Office leases The Company occupies certain office facilities owned by the Exchange and EFL. The Company leases office space on a year-to-year basis from the Exchange. Rent expenses under these leases totaled $10,842, $10,703 and $10,320 in 2001, 2000 and 1999, respectively. The Company has a lease commitment until 2008 with EFL for a branch office. Rentals paid to EFL under this lease totaled $311 in 2001, $309 in 2000 and $303 in 1999. Note receivable from EFL The Company is due $15 million from EFL in the form of a surplus note. The note bears an annual interest rate of 6.45% and all payments of interest and principal of the note may be repaid only out of unassigned surplus of EFL and are subject to prior approval of the Pennsylvania Insurance Commissioner. Interest on the surplus note is scheduled to be paid semi-annually. The note will be payable on demand on or after December 31, 2005. During 2001, 2000 and 1999, EFL paid interest to the Company totaling $968 each year. Structured settlements with EFL The Erie Insurance Group affiliated property/casualty insurance companies periodically purchase annuities from EFL in connection with the structured settlement of claims. The Company's pro-rata share (5.5%) of such annuities purchased equaled $708, $889 and $1,282 in 2001, 2000 and 1999, respectively. 91 INCORPORATED BY REFERENCE, PAGE 44 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS ERIE INDEMNITY COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 11. RECEIVABLES FROM ERIE INSURANCE EXCHANGE AND CONCENTRATIONS OF CREDIT RISK Financial instruments, which potentially expose the Company to concentrations of credit risk, include unsecured receivables from the Exchange. Most all of the Company's revenue and receivables are from the Exchange and affiliates. Management fee and expense reimbursements due from the Exchange were $147,344 and $117,962 in 2001 and 2000, respectively. A receivable from EFL for expense reimbursements totaled $2,256 at December 31, 2001 compared to $1,997 at December 31, 2000. The Company also has a receivable due from the Exchange for reinsurance recoverable from losses and unearned premium balances ceded to the pool totaling $491,055 and $412,050 in 2001 and 2000, respectively. Premiums receivable from Policyholders at December 31, 2001 and 2000 equaled $186,175 and $156,269, respectively. A significant amount of these receivables are ceded to the Exchange as part of the intercompany pooling agreement. At December 31, 2001, the Exchange's statutory total assets totaled almost $7 billion and Policyholders' surplus totaled $3 billion. NOTE 12. REINSURANCE EIC and EINY have an intercompany reinsurance pooling agreement with the Exchange, whereby EIC and EINY cede all of their direct property/casualty insurance to the Exchange, except for the annual premium under the all-lines aggregate excess of loss reinsurance agreement discussed below. EIC and EINY then assume 5% and 0.5%, respectively, of the total of the Exchange's insurance business (including the business assumed from EIC and EINY). The companies settle accounts between them by payment of amounts due within 30 days after the end of each quarterly accounting period. EIC and EINY have in effect an all-lines aggregate excess of loss reinsurance agreement with the Exchange. Under this agreement, EIC and EINY reinsure their net retained share of the intercompany reinsurance pool such that once EIC and EINY have sustained ultimate net losses in any applicable accident year that exceed an amount equal to 72.5% of EIC and EINY's net premiums earned in that period, the Exchange will be liable for 95% of the amount of such excess, up to but not exceeding, an amount equal to 95% of 15% of EIC and EINY's net premium earned. Losses equal to 5% of the net ultimate net loss in excess of the retention under the contract are retained net by EIC and EINY. The annual premium is subject to a minimum premium of $950. This reinsurance treaty is excluded from the intercompany pooling agreement. The annual premium paid to the Exchange for the agreement totaled $1,423, $1,268 and $1,199 in 2001, 2000 and 1999 respectively. Recoveries during 2001 amounted to $7,241, of which $6,506 relates to the 2001 accident year. The balance of the recoveries under this agreement recorded in 2001 related to the 1999 accident year. There were no loss recoveries by EIC or EINY under the agreement for 2000 or 1999. To the extent the Exchange assumes reinsurance business from nonaffiliated sources, the Company participates because of its pooling agreement with the Exchange. Similarly, the Company also participates in the business ceded from the Exchange. Reinsurance premiums, commissions, expense reimbursements and reserves related to reinsurance business are accounted for on bases consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. Premiums ceded to the Exchange have been reported as a reduction of premium income. The Company's property and liability reinsurance assumed from foreign insurance companies is accounted for using the periodic method, whereby premiums are recognized as revenue over the policy term, and claims, including an estimate of claims incurred but not reported, are recognized as they occur. The amount of reinsurance business assumed from foreign insurance companies is not significant. 92 INCORPORATED BY REFERENCE, PAGES 45 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS ERIE INDEMNITY COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 12. REINSURANCE (CONTINUED) Reinsurance contracts do not relieve the Company from its primary obligations to Policyholders. A contingent liability exists with respect to reinsurance receivables in the event reinsurers are unable to meet their obligations under the reinsurance agreements. The following summarizes insurance and reinsurance activities for the Company:
2001 2000 1999 -------------- ------------- ------------- Premiums Earned: Direct $ 432,307 $ 377,570 $ 351,228 Assumed nonaffiliates 7,391 4,824 5,380 Ceded to Erie Insurance Exchange ( 439,698) ( 382,394) ( 356,608) Assumed from Erie Insurance Exchange 137,648 123,708 117,224 ------------- ------------ ------------- Net $ 137,648 $ 123,708 $ 117,224 ============= ============ ============= Losses and Loss Adjustment Expenses Incurred: Direct $ 374,440 $ 325,644 $ 264,177 Assumed nonaffiliates 14,262 3,956 6,512 Ceded to Erie Insurance Exchange ( 388,702) ( 329,600) ( 270,689) Assumed from Erie Insurance Exchange 117,201 99,564 87,719 ------------- ------------ ------------- Net $ 117,201 $ 99,564 $ 87,719 ============= ============ =============
NOTE 13. STATUTORY INFORMATION The statutory financial statements of Erie Insurance Property & Casualty Company and EIC are prepared in accordance with accounting practices prescribed by the Pennsylvania Insurance Department. EINY prepares its statutory financial statements in accordance with accounting practices prescribed by the New York Insurance Department. Prescribed Statutory Accounting Practices (SAP) include state laws, regulations, and general administration rules, as well as a variety of publications from the National Association of Insurance Commissioners (NAIC). The NAIC adopted the Codification of Statutory Accounting Practices (Codification), effective January 1, 2001, as the NAIC-supported basis of accounting. The Codification was approved with a provision allowing for prescribed or permitted accounting practices to be determined by each states' insurance commissioner. Accordingly, such discretion will continue to allow prescribed or permitted accounting practices that may differ from state to state. The New York State Insurance Department did not adopt the deferred tax provisions of Codification, thus no deferred taxes are recorded on the EINY statutory financial statements. Codification resulted in changes to the Company's statutory-basis financial statements, the most significant of which was the recording of statutory deferred taxes for EIC and Erie Insurance Property & Casualty Company. The total cumulative adjustment increased the surplus of the Company's property/casualty insurance subsidiaries by $4,446 as of January 1, 2001. 93 INCORPORATED BY REFERENCE, PAGES 45 AND 46 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS ERIE INDEMNITY COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 13. STATUTORY INFORMATION (CONTINUED) Accounting principles used to prepare statutory financial statements differ from those used to prepare financial statements on the basis of generally accepted accounting principles. Consolidated balances including amounts reported by the property/casualty insurance subsidiaries on the statutory basis would be as follows:
2001 2000 1999 ----------- ----------- ------------ Shareholders' equity at December 31, $ 854,003 $ 767,894 $ 688,802 Net income for the year ended December 31, 118,475 150,942 142,615
The amount of dividends the Company's Pennsylvania-domiciled property/casualty subsidiaries, EIC and Erie Insurance Property & Casualty Company, can pay without the prior approval of the Pennsylvania Insurance Commissioner is limited by Pennsylvania regulation to not more than the greater of: (a) 10% of its statutory surplus as reported on its last annual statement, or (b) the net income as reported on its last annual statement. The amount of dividends that the Erie Insurance Company's New York-domiciled property/casualty subsidiary, EINY, can pay without the prior approval of the New York Superintendent of Insurance is limited to the lesser of: (a) 10% of its statutory surplus as reported on its last annual statement, or (b) 100% of its adjusted net investment income during such period. At December 31, 2001, the maximum dividend the Company could receive from its property/casualty insurance subsidiaries was $5,491. No dividends were paid to the Company from its property/casualty insurance subsidiaries in 2001 or 2000. The amount of dividends EFL, a Pennsylvania-domiciled life insurer, can pay to its shareholders without the prior approval of the Pennsylvania Insurance Commissioner is limited by statute to the greater of: (a) 10% of its statutory surplus as regards Policyholders as shown on its last annual statement on file with the commissioner, or (b) the net income as reported for the period covered by such annual statement, but shall not include pro rata distribution of any class of the insurer's own securities. Accordingly, the Company's share of the maximum dividend payout which may be made in 2002 without prior Pennsylvania Commissioner approval is $2,295. Dividends to the Company totaled $1,594 in 2001 and $1,472 in 2000. NOTE 14. COMMITMENTS The Company has outstanding commitments to invest up to $124,000 in limited partnerships at December 31, 2001. These commitments will be funded as required through the end of the respective investment periods, which typically span 3 to 5 years expiring in 2005. At December 31, 2001, the total commitment to fund limited partnerships that invest in private equity securities is $87,000, real estate activities $22,000 and fixed income securities $15,000. At December 31, 2001, no one partnership commitment exceeded $7.5 million, or 6%, of the outstanding commitment amount. During 2001, the Company entered into contracts to provide services related to the eCommerce program with various external vendors. The total outstanding commitment for these contracts at December 31, 2001, was $16,146, of which approximately $12,943 will be reimbursed to the Company by the Exchange. The majority of these committed services at December 31, 2001, are expected to be performed in 2002. 94 INCORPORATED BY REFERENCE, PAGE 46 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS ERIE INDEMNITY COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 15. SEGMENT INFORMATION The Company operates its business as two reportable segments - management operations and property/casualty insurance operations. Accounting policies for segments are the same as those described in the summary of significant accounting policies. See also Note 2. Assets are not allocated to the segments and are reviewed in total by management for purposes of decision making. No single customer or agent provides 10% or more of revenues for the Exchange. The Company's principal operations consist of serving as attorney-in-fact for the Exchange, which constitute its management operations. The Company's property/casualty insurance operations arise through direct business of its subsidiaries and by virtue of the pooling agreement between its subsidiaries and the Exchange, which includes assumed reinsurance from nonaffiliated domestic and foreign sources. Insurance provided in the property/casualty operations consists of personal and commercial lines and is sold by independent agents. Personal lines are marketed to individuals and commercial lines are marketed to small and medium-sized businesses. The performance of the personal lines and commercial lines is evaluated based upon the underwriting results as determined under SAP for the total pooled business of the Group. Summarized financial information for these operations is presented below.
2001 2000 1999 ------------- ------------- ------------- Management operations: --------------------- Revenue: Management fee revenue $ 634,966 $ 551,646 $ 513,375 Service agreement revenue 27,247 22,662 15,441 ------------ ------------ ------------ Total revenue from management operations 662,213 574,308 528,816 Net revenue from investment operations 1,700 57,213 47,011 ------------ ------------ ------------ Total revenue $ 663,913 $ 631,521 $ 575,827 ============ ============ ============ Income before taxes $ 186,267 $ 215,959 $ 195,529 ============ ============ ============ Net income $ 123,403 $ 145,851 $ 133,235 ============ ============ ============ Property/casualty operations: ---------------------------- Revenue: Premiums earned: Commercial lines $ 34,970 $ 28,456 $ 25,147 Personal lines 97,078 89,369 87,334 Reinsurance 8,866 7,880 6,185 ------------ ------------ ------------ Total premiums earned (SAP) 140,914 125,705 118,666 GAAP adjustments ( 3,266) ( 1,997) ( 1,442) ------------ ------------ ------------ Total premiums earned (GAAP) 137,648 123,708 117,224 Net revenue from investment operations 17,071 18,381 16,765 ------------ ------------ ------------ Total revenue $ 154,719 $ 142,089 $ 133,989 ============ ============ ============ Expense: Losses and expenses: Commercial lines $ 41,417 $ 31,914 $ 26,726 Personal lines 107,851 92,012 85,512 Reinsurance 12,970 12,203 9,225 ------------ ------------ ------------ Total losses and expenses (SAP) 162,238 136,129 121,463 GAAP adjustments ( 4,127) ( 2,019) ( 700) ------------ ------------ ------------ Total losses and expenses (GAAP) $ 158,111 $ 134,110 $ 120,763 ============ ============ ============ (Loss) income before taxes ($ 3,391) $ 7,979 $ 13,226 ============ ============ ============ Net (loss) income ($ 1,142) $ 6,542 $ 9,871 ============ ============ ============
95 INCORPORATED BY REFERENCE, PAGE 47 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS ERIE INDEMNITY COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 16. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
First Second Third Fourth Quarter Quarter Quarter Quarter ----------- ----------- ----------- ----------- 2001 ---- Net revenue from management operations $ 43,200 $ 53,104 $ 55,044 $ 33,220 Underwriting loss ( 3,538) ( 1,786) ( 10,589) ( 4,550) Net revenue (loss) from investment operations 12,196 18,731 6,994 ( 19,150) ---------- ---------- ---------- ---------- Income before income taxes 51,858 70,049 51,449 9,520 ========== ========== ========== ========== Net income $ 34,785 $ 47,129 $ 34,430 $ 5,917 ========== ========== ========== ========== Net income per share $ 0.49 $ 0.66 $ 0.48 $ 0.08 ========== ========== ========== ========== Comprehensive income $ 36,407 $ 45,414 $ 31,081 $ 21,399 ========== ========== ========== ========== 2000 ---- Net revenue from management operations $ 36,618 $ 43,310 $ 44,417 $ 34,401 Underwriting loss ( 3,203) ( 1,590) ( 2,742) ( 2,867) Net revenue from investment operations 19,515 20,658 18,986 16,435 ---------- ---------- ---------- ---------- Income before income taxes 52,930 62,378 60,661 47,969 ========== ========== ========== ========== Net income $ 36,185 $ 42,518 $ 41,192 $ 32,498 ========== ========== ========== ========== Net income per share $ 0.50 $ 0.59 $ 0.58 $ 0.45 ========== ========== ========== ========== Comprehensive income $ 50,036 $ 35,093 $ 41,565 $ 22,300 ========== ========== ========== ========== 1999 ---- Net revenue from management operations $ 34,367 $ 40,587 $ 41,945 $ 31,619 Underwriting (loss) gain ( 607) 1,113 ( 1,580) ( 2,465) Net revenue from investment operations 14,770 16,177 16,450 16,379 ---------- ---------- ---------- ---------- Income before income taxes 48,530 57,877 56,815 45,533 ========== ========== ========== ========== Net income $ 33,407 $ 39,225 $ 38,425 $ 32,049 ========== ========== ========== ========== Net income per share $ 0.45 $ 0.53 $ 0.53 $ 0.44 ========== ========== ========== ========== Comprehensive income $ 31,897 $ 32,180 $ 26,295 $ 39,137 ========== ========== ========== ==========
During the fourth quarter of 2001, the Company realized net losses on the sale of impaired securities and realized charges for other-than-temporary impairments of equity securities and limited partnerships totaling $29,153. Realized losses resulted in an after-tax earnings per share reduction of $0.27. The investment sales were part of a proactive year-end tax planning strategy and will produce the recovery of approximately $9.6 million of federal income taxes paid in 1998, 1999 and 2000. Also contributing to the fourth quarter 2001 decline in net income per share were charges for a severance benefit stemming from the retirement of the president and CEO of the Erie Insurance Group. The Company's share of charges related to this severance was approximately $0.10 per share, after taxes. 96 INCORPORATED BY REFERENCE, PAGE 48 OF THE COMPANY'S 2001 ANNUAL REPORT TO SHAREHOLDERS MARKET PRICE OF AND DIVIDENDS ON THE COMMON STOCK AND RELATED SHAREHOLDER MATTERS COMMON STOCK PRICES The Class A non-voting common stock of the Company trades on The NASDAQ Stock Market under the symbol "ERIE." The following sets forth the range of high and low trading prices by quarter as reported by The NASDAQ Stock Market. CLASS A TRADING PRICE 2001 2000 Low High Low High -------------------------------------------------------------------- First Quarter 25.63 30.13 26.25 32.63 Second Quarter 27.54 36.12 27.50 32.88 Third Quarter 30.83 39.70 28.25 32.13 Fourth Quarter 36.65 41.27 23.88 30.00 -------------------------------------------------------------------- No established trading market exists for the Class B voting common stock. On February 18, 1997, the Executive Committee of the Board of Directors approved an enhancement to the Company's 401(K) plan for Employees which permits participants to invest a portion of the Company's contributions to the plan in shares of Erie Indemnity Class A common stock. The plan's Trustee was authorized to buy Erie Indemnity Company Class A common stock on behalf of 401(K) plan participants beginning May 8, 1997. In 1998, the Board of Directors of the Company approved a stock repurchase plan beginning January 1, 1999, under which the Company may repurchase as much as $120 million of its outstanding Class A common stock through December 31, 2002. Treasury shares are recorded on the Consolidated Statements of Financial Position at cost. In 2001, there were 220,000 shares repurchased at a total cost of $7,653,916, or an average price per share of $34.79. Since its inception, 3,195,677 shares have been repurchased at a total cost of $93,373,265, or an average price per share of $29.22. The Company may purchase the shares from time to time in the open market or through privately negotiated transactions, depending on prevailing market conditions and alternative uses of the Company's capital. COMMON STOCK DIVIDENDS The Company historically has declared and paid cash dividends on a quarterly basis at the discretion of the Board of Directors. The payment and amount of future dividends on the common stock will be determined by the Board of Directors and will depend on, among other things, earnings, financial condition and cash requirements of the Company at the time such payment is considered, and on the ability of the Company to receive dividends from its subsidiaries, the amount of which is subject to regulatory limitations. Dividends declared for each class of stock during 2001 and 2000 are as follows: DIVIDENDS DECLARED 2001: Class A share Class B share --------------------------------------------------------------- First Quarter $ .1525 $ 22.875 Second Quarter .1525 22.875 Third Quarter .1525 22.875 Fourth Quarter .1700 25.500 --------------------------------------------------------------- $ .6275 $ 94.125 =============================================================== 2000: Class A share Class B share --------------------------------------------------------------- First Quarter $ .1350 $ 20.250 Second Quarter .1350 20.250 Third Quarter .1350 20.250 Fourth Quarter .1525 22.875 --------------------------------------------------------------- $ .5575 $ 83.625 =============================================================== American Stock Transfer & Trust Company serves as the Company's transfer agent and registrar. 97