Document
Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended June 30, 2016
 
Commission file number 0-24000
 
 
ERIE INDEMNITY COMPANY
 
 
(Exact name of registrant as specified in its charter)
 
 
PENNSYLVANIA
 
25-0466020
 
 
(State or other jurisdiction of
 
(I.R.S. Employer
 
 
incorporation or organization)
 
Identification No.)
 
 
 
100 Erie Insurance Place, Erie, Pennsylvania
 
16530
 
 
(Address of principal executive offices)
 
(Zip Code)
 
 
 
 
 
 
 
(814) 870-2000
 
 
(Registrant’s telephone number, including area code)
 
 
Not applicable
 
 
(Former name, former address and former fiscal year, if changed since last report)
 
  
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes  X   No ___
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes  X   No ___
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes  X   No ___
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):
 
Large Accelerated Filer  X    Accelerated Filer ___ Non-Accelerated Filer ___ Smaller Reporting Company ___
(Do not check if a smaller reporting company)
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes          No   X
 
The number of shares outstanding of the registrant’s Class A Common Stock as of the latest practicable date, with no par value and a stated value of $0.0292 per share, was 46,189,068 at July 15, 2016.
 
The number of shares outstanding of the registrant’s Class B Common Stock as of the latest practicable date, with no par value and a stated value of $70 per share, was 2,542 at July 15, 2016.


Table of Contents

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

2

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1.
FINANCIAL STATEMENTS

ERIE INDEMNITY COMPANY
STATEMENTS OF OPERATIONS (UNAUDITED)
(dollars in thousands, except per share data)

 
 
Three months ended
 
Six months ended
 
 
June 30,
 
June 30,
 
 
2016
 
2015
 
2016
 
2015
Operating revenue
 
 
 
 
 
 

 
 

Management fee revenue, net
 
$
416,665

 
$
394,224

 
$
784,123

 
$
737,458

Service agreement revenue
 
7,219

 
7,436

 
14,489

 
15,033

Total operating revenue
 
423,884

 
401,660

 
798,612

 
752,491

 
 
 
 
 
 
 
 
 
Operating expenses
 
 
 
 
 
 
 
 
Commissions
 
235,794

 
223,731

 
444,508

 
417,448

Salaries and employee benefits
 
55,025

 
57,354

 
108,314

 
112,373

All other operating expenses
 
47,306

 
50,592

 
92,366

 
100,257

Total operating expenses
 
338,125

 
331,677

 
645,188

 
630,078

Net revenue from operations
 
85,759

 
69,983

 
153,424

 
122,413

 
 
 
 
 
 
 
 
 
Investment income
 
 
 
 
 
 
 
 
Net investment income
 
4,891

 
4,435

 
9,553

 
8,976

Net realized investment gains (losses)
 
399

 
598

 
(689
)
 
358

Net impairment losses recognized in earnings
 
0

 
(35
)
 
(345
)
 
(155
)
Equity in earnings of limited partnerships
 
2,114

 
10,707

 
1,444

 
13,065

Total investment income
 
7,404

 
15,705

 
9,963

 
22,244

Income before income taxes
 
93,163

 
85,688

 
163,387

 
144,657

Income tax expense
 
31,854

 
29,538

 
56,183

 
49,674

Net income
 
$
61,309

 
$
56,150

 
$
107,204

 
$
94,983

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Earnings Per Share
 
 
 
 
 
 

 
 

Net income per share
 
 
 
 
 
 

 
 

Class A common stock – basic
 
$
1.32

 
$
1.21

 
$
2.30

 
$
2.04

Class A common stock – diluted
 
$
1.17

 
$
1.07

 
$
2.04

 
$
1.81

Class B common stock – basic
 
$
197

 
$
181

 
$
345

 
$
306

Class B common stock – diluted
 
$
197

 
$
180

 
$
345

 
$
305

 
 
 
 
 
 
 
 
 
Weighted average shares outstanding – Basic
 
 
 
 
 
 

 
 

Class A common stock
 
46,188,867

 
46,189,068

 
46,188,967

 
46,189,068

Class B common stock
 
2,542

 
2,542

 
2,542

 
2,542

 
 
 
 
 
 
 
 
 
Weighted average shares outstanding – Diluted
 
 
 
 
 
 

 
 

Class A common stock
 
52,392,862

 
52,562,514

 
52,458,394

 
52,598,633

Class B common stock
 
2,542

 
2,542

 
2,542

 
2,542

 
 
 
 
 
 
 
 
 
Dividends declared per share
 
 
 
 
 
 

 
 

Class A common stock
 
$
0.730

 
$
0.681

 
$
1.460

 
$
1.362

Class B common stock
 
$
109.500

 
$
102.150

 
$
219.000

 
$
204.300

 
 
See accompanying notes to Financial Statements. See Note 10, "Accumulated Other Comprehensive Income (Loss)", for amounts reclassified out of accumulated other comprehensive income (loss) into the Statements of Operations. 

3

Table of Contents

ERIE INDEMNITY COMPANY
STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)
(in thousands)

 
 
Three months ended
Six months ended
 
 
June 30,
June 30,
 
 
2016
 
2015
2016
 
2015
Net income
 
$
61,309

 
$
56,150

$
107,204

 
$
94,983

 
 
 
 
 
 
 
 
Other comprehensive income (loss), net of tax
 
 
 
 
 

 
 

Change in unrealized holding gains (losses) on available-for-sale securities
 
3,026

 
(2,583
)
6,491

 
(2,483
)
 
 
 
 
 
 
 
 
Comprehensive income
 
$
64,335

 
$
53,567

$
113,695

 
$
92,500

 
See accompanying notes to Financial Statements. See Note 10, "Accumulated Other Comprehensive Income (Loss)", for amounts reclassified out of accumulated other comprehensive income (loss) into the Statements of Operations.

4

Table of Contents

ERIE INDEMNITY COMPANY
STATEMENTS OF FINANCIAL POSITION
(dollars in thousands, except per share data)

 
 
 
June 30,
 
December 31,
 
 
2016
 
2015
Assets
 
(Unaudited)
 
 
Current assets:
 
 
 
 
Cash and cash equivalents
 
$
124,111

 
$
182,889

Available-for-sale securities
 
46,087

 
62,067

Trading securities
 
496

 

Receivables from Erie Insurance Exchange and affiliates
 
387,273

 
348,055

Prepaid expenses and other current assets
 
33,885

 
24,697

Federal income taxes recoverable
 
0

 
11,947

Accrued investment income
 
5,816

 
5,491

Total current assets
 
597,668

 
635,146

 
 
 
 
 
Available-for-sale securities
 
607,548

 
537,874

Limited partnership investments
 
70,952

 
88,535

Fixed assets, net
 
58,986

 
59,087

Deferred income taxes, net
 
35,780

 
40,686

Note receivable from Erie Family Life Insurance Company
 
25,000

 
25,000

Other assets
 
18,892

 
20,968

Total assets
 
$
1,414,826

 
$
1,407,296

 
 
 
 
 
Liabilities and shareholders' equity
 
 
 
 
Current liabilities:
 
 
 
 
Commissions payable
 
$
217,203

 
$
195,542

Agent bonuses
 
58,235

 
106,752

Accounts payable and accrued liabilities
 
90,856

 
88,532

Dividends payable
 
33,996

 
33,996

Deferred executive compensation
 
13,252

 
20,877

Federal income taxes payable
 
1,960

 
0

Total current liabilities
 
415,502

 
445,699

 
 
 
 
 
Defined benefit pension plans
 
170,619

 
172,700

Employee benefit obligations
 
910

 
1,234

Deferred executive compensation
 
12,461

 
16,580

Other long-term liabilities
 
140

 
1,580

Total liabilities
 
599,632

 
637,793

 
 
 
 
 
Shareholders’ equity
 
 
 
 
Class A common stock, stated value $0.0292 per share; 74,996,930 shares authorized; 68,299,200 shares issued; 46,189,068 shares outstanding
 
1,992

 
1,992

Class B common stock, convertible at a rate of 2,400 Class A shares for one Class B share, stated value $70 per share; 3,070 shares authorized; 2,542 shares issued and outstanding
 
178

 
178

Additional paid-in-capital
 
16,300

 
16,311

Accumulated other comprehensive loss
 
(90,373
)
 
(96,864
)
Retained earnings
 
2,033,187

 
1,993,976

Total contributed capital and retained earnings
 
1,961,284

 
1,915,593

Treasury stock, at cost; 22,110,132 shares held
 
(1,155,301
)
 
(1,155,108
)
Deferred compensation
 
9,211

 
9,018

Total shareholders’ equity
 
815,194

 
769,503

Total liabilities and shareholders’ equity
 
$
1,414,826

 
$
1,407,296

 
See accompanying notes to Financial Statements. 

5

Table of Contents

ERIE INDEMNITY COMPANY
STATEMENTS OF CASH FLOWS (UNAUDITED)
(in thousands)

 
 
Six months ended
 
 
June 30,
 
 
2016
 
2015
Cash flows from operating activities
 
 
 
 
Management fee received
 
$
757,193

 
$
714,217

Service agreement fee received
 
14,489

 
15,033

Net investment income received
 
12,921

 
12,980

Limited partnership distributions
 
5,418

 
9,360

Decrease in reimbursements collected from affiliates
 
(12,288
)
 
(10,415
)
Commissions paid to agents
 
(363,968
)
 
(345,986
)
Agents bonuses paid
 
(107,170
)
 
(90,245
)
Salaries and wages paid
 
(90,509
)
 
(78,266
)
Pension contribution and employee benefits paid
 
(31,631
)
 
(28,263
)
General operating expenses paid
 
(91,715
)
 
(110,519
)
Income taxes paid
 
(42,258
)
 
(46,018
)
Net cash provided by operating activities
 
50,482

 
41,878

 
 
 
 
 
Cash flows from investing activities
 
 
 
 
Purchase of investments:
 
 
 
 
Available-for-sale securities
 
(161,835
)
 
(111,216
)
Limited partnerships
 
(367
)
 
(597
)
Proceeds from investments:
 
 
 
 
Available-for-sale securities
 
112,030

 
108,939

Trading securities
 
3,146

 

Limited partnerships
 
11,246

 
14,708

Net purchase of fixed assets
 
(7,257
)
 
(5,266
)
Net collections (distributions) on agent loans
 
1,770

 
(184
)
Net cash (used in) provided by investing activities
 
(41,267
)
 
6,384

 
 
 
 
 
Cash flows from financing activities
 
 
 
 
Dividends paid to shareholders
 
(67,993
)
 
(63,429
)
Net cash used in financing activities
 
(67,993
)
 
(63,429
)
 
 
 
 
 
Net decrease in cash and cash equivalents
 
(58,778
)
 
(15,167
)
Cash and cash equivalents, beginning of period
 
182,889

 
91,747

Cash and cash equivalents, end of period
 
$
124,111

 
$
76,580

  
See accompanying notes to Financial Statements.

6

Table of Contents

NOTES TO FINANCIAL STATEMENTS (UNAUDITED)
 
Note 1.  Nature of Operations
 
Erie Indemnity Company ("Indemnity", "we", "us", "our") is a publicly held Pennsylvania business corporation that has since its incorporation in 1925 served as the attorney-in-fact for the subscribers (policyholders) at the Erie Insurance Exchange ("Exchange").  The Exchange, which also commenced business in 1925, is a Pennsylvania-domiciled reciprocal insurer that writes property and casualty insurance. We function solely as the management company and all insurance operations are performed by the Exchange.
 
Our primary function, as attorney-in-fact, is to perform certain services for the Exchange relating to the sales, underwriting, and issuance of policies on behalf of the Exchange.  This is done in accordance with a subscriber’s agreement (a limited power of attorney) executed individually by each subscriber (policyholder), which appoints us as their common attorney-in-fact to transact certain business on their behalf and to manage the affairs of the Exchange.  Pursuant to the subscriber’s agreement and for its services as attorney-in-fact, we earn a management fee calculated as a percentage of the direct and assumed premiums written by the Exchange.

The services we provide to the Exchange are related to the sales, underwriting and issuance of policies. The sales related services we provide include agent compensation and certain sales and advertising support services. Agent compensation includes scheduled commissions to agents based upon premiums written as well as additional commissions and bonuses to agents, which are earned by achieving targeted measures. The underwriting services we provide include underwriting and policy processing. The remaining services we provide include customer service and administrative support. We also provide information technology services that support all the functions listed above.

By virtue of its legal structure as a reciprocal insurer, the Exchange does not have the ability to enter into contractual relationships and therefore Indemnity serves as the attorney-in-fact on behalf of the Exchange for all claims handling services and certain other common overhead and service department functions in accordance with the subscriber’s agreement. The amounts Indemnity incurs on behalf of the Exchange in this capacity are reimbursed to Indemnity from the Exchange at cost. See Note 11, "Related Party" contained within this report.

Our results of operations are tied to the growth and financial condition of the Exchange. If any events occurred that impaired the Exchange’s ability to grow or sustain its financial condition, including but not limited to reduced financial strength ratings, disruption in the independent agency relationships, significant catastrophe losses, or products not meeting customer demands, the Exchange could find it more difficult to retain its existing business and attract new business. A decline in the business of the Exchange almost certainly would have as a consequence a decline in the total premiums paid and a correspondingly adverse effect on the amount of the management fees we receive. We also have an exposure to a concentration of credit risk related to the unsecured receivables due from the Exchange for its management fee. See Note 12, "Concentrations of Credit Risk" contained within this report.



7

Table of Contents

Note 2.  Significant Accounting Policies

Basis of presentation
The accompanying unaudited financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP") for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the six months ended June 30, 2016 are not necessarily indicative of the results that may be expected for the year ending December 31, 2016. For further information, refer to the financial statements and footnotes included in our Form 10-K for the year ended December 31, 2015 as filed with the Securities and Exchange Commission on February 25, 2016.

The preparation of financial statements in conformity with GAAP requires us 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.

Certain prior period amounts have been reclassified on the statements of financial position to conform to the current period presentation. These reclassifications had no effect on the previously reported results of operations.

Recently issued accounting standards
In February 2015, the Financial Accounting Standards Board ("FASB") updated Accounting Standards Codification ("ASC") 810 "Consolidation", which amended the existing guidance for determining if a reporting entity has a variable interest in a legal entity. We adopted the new accounting principle on a retrospective basis as of December 31, 2015. In accordance with the new accounting guidance, Indemnity is not deemed to have a variable interest in the Exchange as the fees paid for services provided to the Exchange no longer represent a variable interest. The compensation received from the attorney-in-fact fee arrangement with the subscribers is for services provided by Indemnity acting in its role as attorney-in-fact and is commensurate with the level of effort required to perform those services. Under the previously issued accounting guidance, Indemnity was deemed to be the primary beneficiary of the Exchange and its financial position and operating results were consolidated with Indemnity. Following adoption of the new accounting guidance, the Exchange’s results are no longer required to be consolidated with Indemnity. There was no cumulative effect to Indemnity's shareholders’ equity or net income from no longer consolidating the Exchange's results with ours.

In June 2016, the FASB issued Accounting Standards Update ("ASU") 2016-13, "Financial Instruments-Credit Losses", which requires financial assets measured at amortized cost to be presented at the net amount expected to be collected through the use of a new forward-looking expected loss model and credit losses relating to available-for-sale debt securities to be recognized through an allowance for credit losses. ASU 2016-13 is effective for interim and annual reporting periods beginning after December 15, 2019. Early adoption for interim and annual periods beginning after December 15, 2018 is permitted. We are currently evaluating the potential impact of this guidance on our financial statements.

In February 2016, the FASB issued ASU 2016-02, "Leases", which requires lessees to recognize assets and liabilities arising from operating leases on the statement of financial position and to disclose key information about leasing arrangements. ASU 2016-02 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. Early adoption is permitted. We are currently evaluating the potential impact of this guidance on our financial statements.

In January 2016, the FASB issued ASU 2016-01, "Financial Instruments-Overall".  ASU 2016-01 revises the accounting related to the classification and measurement of investments in equity securities and the presentation of certain fair value changes for financial liabilities measured at fair value.  ASU 2016-01 is effective for interim and annual reporting periods beginning after December 15, 2017.  We are currently evaluating the potential impact of this guidance on our financial statements.

In May 2014, the FASB issued ASU 2014-09, "Revenue from Contracts with Customers". ASU 2014-09 requires an entity to recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance is effective for fiscal years beginning after December 15, 2017 including interim periods within that reporting period. We do not expect the adoption of this guidance to have a material impact on our financial statements.    


8

Table of Contents

Note 3.  Earnings Per Share
 
Class A and Class B basic earnings per share and Class B diluted earnings per share are calculated under the two-class method. The two-class method allocates earnings to each class of stock based upon its dividend rights.  Class B shares are convertible into Class A shares at a conversion ratio of 2,400 to 1. See Note 9, "Capital Stock".

Class A diluted earnings per share are calculated under the if-converted method, which reflects the conversion of Class B shares to Class A shares. Diluted earnings per share calculations include the dilutive effect of assumed issuance of stock-based awards under compensation plans that have the option to be paid in stock using the treasury stock method.

A reconciliation of the numerators and denominators used in the basic and diluted per-share computations is presented as follows for each class of common stock:
 
(dollars in thousands, except per share data)
 
Three months ended June 30,
 
 
2016
 
2015
 
 
Allocated net income (numerator)
 
Weighted shares (denominator)
 
Per-share amount
 
Allocated net income (numerator)
 
Weighted shares (denominator)
 
Per-share amount
Class A – Basic EPS:
 
 
 
 
 
 
 
 
 
 
 
 
Income available to Class A stockholders
 
$
60,807

 
46,188,867

 
$
1.32

 
$
55,690

 
46,189,068

 
$
1.21

Dilutive effect of stock-based awards
 
0

 
103,195

 

 
0

 
272,646

 

Assumed conversion of Class B shares
 
502

 
6,100,800

 

 
460

 
6,100,800

 

Class A – Diluted EPS:
 
 
 
 
 
 
 
 
 
 
 
 
Income available to Class A stockholders on Class A equivalent shares
 
$
61,309

 
52,392,862

 
$
1.17

 
$
56,150

 
52,562,514

 
$
1.07

Class B – Basic EPS:
 
 
 
 
 
 
 
 
 
 
 
 
Income available to Class B stockholders
 
$
502

 
2,542

 
$
197

 
$
460

 
2,542

 
$
181

Class B – Diluted EPS:
 
 
 
 
 
 
 
 
 
 
 
 
Income available to Class B stockholders
 
$
502

 
2,542

 
$
197

 
$
458

 
2,542

 
$
180

  
(dollars in thousands, except per share data)
 
Six months ended June 30,
 
 
2016
 
2015
 
 
Allocated net income (numerator)
 
Weighted shares (denominator)
 
Per-share amount
 
Allocated net income (numerator)
 
Weighted shares (denominator)
 
Per-share amount
Class A – Basic EPS:
 
 

 
 

 
 

 
 

 
 

 
 

Income available to Class A stockholders
 
$
106,327

 
46,188,967

 
$
2.30

 
$
94,205

 
46,189,068

 
$
2.04

Dilutive effect of stock-based awards
 
0

 
168,627

 

 
0

 
308,765

 

Assumed conversion of Class B shares
 
877

 
6,100,800

 

 
778

 
6,100,800

 

Class A – Diluted EPS:
 
 

 
 

 
 

 
 

 
 

 
 

Income available to Class A stockholders on Class A equivalent shares
 
$
107,204

 
52,458,394

 
$
2.04

 
$
94,983

 
52,598,633

 
$
1.81

Class B – Basic EPS:
 
 

 
 

 
 

 
 

 
 

 
 

Income available to Class B stockholders
 
$
877

 
2,542

 
$
345

 
$
778

 
2,542

 
$
306

Class B – Diluted EPS:
 
 
 
 
 
 
 
 
 
 
 
 
Income available to Class B stockholders
 
$
877

 
2,542

 
$
345

 
$
776

 
2,542

 
$
305


9

Table of Contents

Note 4. Fair Value
 
Our available-for-sale and trading securities are recorded at fair value, which is the price that would be received to sell the asset in an orderly transaction between willing market participants as of the measurement date.
 
Valuation techniques used to derive the fair value of our available-for-sale and trading securities are based upon observable and unobservable inputs.  Observable inputs reflect market data obtained from independent sources.  Unobservable inputs reflect our own assumptions regarding fair market value for these securities.  Although the majority of our prices are obtained from third party sources, we also perform an internal pricing review for securities with low trading volumes under current market conditions. Financial instruments are categorized based upon the following characteristics or inputs to the valuation techniques:
 
Level 1 – Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity can access at the measurement date.

Level 2 – Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

Level 3 – Unobservable inputs for the asset or liability.
 
Estimates of fair values for our investment portfolio are obtained primarily from a nationally recognized pricing service.  Our Level 1 category includes those securities valued using an exchange traded price provided by the pricing service.  The methodologies used by the pricing service that support a Level 2 classification of a financial instrument include multiple verifiable, observable inputs including benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data.  Pricing service valuations for Level 3 securities are based upon proprietary models and are used when observable inputs are not available or in illiquid markets.
 
In limited circumstances we adjust the price received from the pricing service when, in our judgment, a better reflection of fair value is available based upon corroborating information and our knowledge and monitoring of market conditions such as a disparity in price of comparable securities and/or non-binding broker quotes.  In other circumstances, certain securities are internally priced because prices are not provided by the pricing service.
 
We perform continuous reviews of the prices obtained from the pricing service.  This includes evaluating the methodology and inputs used by the pricing service to ensure that we determine the proper classification level of the financial instrument.  Price variances, including large periodic changes, are investigated and corroborated by market data.  We have reviewed the pricing methodologies of our pricing service as well as other observable inputs, such as data, and transaction volumes and believe that their prices adequately consider market activity in determining fair value.  Our review process continues to evolve based upon accounting guidance and requirements.
 
When a price from the pricing service is not available, values are determined by obtaining broker/dealer quotes and/or market comparables.  When available, we obtain multiple quotes for the same security.  The ultimate value for these securities is determined based upon our best estimate of fair value using corroborating market information.  Our evaluation includes the consideration of benchmark yields, reported trades, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data.
 
For certain securities in an illiquid market, there may be no prices available from a pricing service and no comparable market quotes available.  In these situations, we value the security using an internally-developed, risk-adjusted discounted cash flow model.


10

Table of Contents

The following tables present our fair value measurements on a recurring basis by asset class and level of input:
 
 
 
At June 30, 2016
 
 
Fair value measurements using:
(in thousands)
 
 
Total
 
Quoted prices in
active markets for identical assets
Level 1
 
Observable inputs
Level 2
 
Unobservable inputs
Level 3
Available-for-sale securities:
 
 
 
 
 
 
 
 
States & political subdivisions
 
$
241,824

 
$
0

 
$
241,824

 
$
0

Corporate debt securities
 
290,028

 
0

 
281,177

 
8,851

Residential mortgage-backed securities
 
14,029

 
0

 
14,029

 
0

Commercial mortgage-backed securities
 
40,023

 
0

 
39,020

 
1,003

Collateralized debt obligations
 
56,633

 
0

 
55,433

 
1,200

Other debt securities
 
1,984

 
0

 
1,984

 
0

Total fixed maturities
 
644,521

 
0

 
633,467

 
11,054

Common stock
 
9,114

 
9,114

 
0

 
0

Total available-for-sale securities
 
653,635

 
9,114

 
633,467

 
11,054

Trading securities:
 
 
 
 
 
 
 
 
Common stock
 
496

 
496

 
0

 
0

Other investments (1)
 
3,908

 

 

 

Total
 
$
658,039

 
$
9,610

 
$
633,467

 
$
11,054


 
 
At December 31, 2015
 
 
Fair value measurements using:
(in thousands)
 
 
Total
 
Quoted prices in
active markets for
identical assets
Level 1
 
Observable
inputs
Level 2
 
Unobservable
inputs
Level 3
Available-for-sale securities:
 
 
 
 
 
 
 
 
States & political subdivisions
 
$
231,847

 
$
0

 
$
231,847

 
$
0

Corporate debt securities
 
250,333

 
0

 
250,264

 
69

Residential mortgage-backed securities
 
13,513

 
0

 
13,513

 
0

Commercial mortgage-backed securities
 
37,571

 
0

 
37,571

 
0

Collateralized debt obligations
 
51,745

 
0

 
43,168

 
8,577

Other debt securities
 
2,200

 
0

 
2,200

 
0

Total fixed maturities
 
587,209

 
0

 
578,563

 
8,646

Common stock
 
12,732

 
12,732

 
0

 
0

Total available-for-sale securities
 
599,941

 
12,732

 
578,563

 
8,646

Other investments (1)
 
4,526

 

 

 

Total
 
$
604,467

 
$
12,732

 
$
578,563

 
$
8,646


(1)          Other investments measured at fair value represent real estate funds included on the balance sheet as limited partnership investments that are reported under the fair value option using the net asset value practical expedient. These amounts are not required to be categorized in the fair value hierarchy. The investments can never be redeemed with the funds. Instead, distributions are received when liquidation of the underlying assets of the funds occur. It is estimated that the underlying assets will generally be liquidated between 5 and 10 years from the inception of the funds. The fair value of these investments is based on the net asset value (NAV) information provided by the general partner. Fair value is based on our proportionate share of the NAV based on the most recent partners' capital statements received from the general partners, which is generally one quarter prior to our balance sheet date. These values are then analyzed to determine if the NAV represents fair value at our balance sheet date, with adjustment being made where appropriate. We consider observable market data and perform a review validating the appropriateness of the NAV at each balance sheet date. It is likely that all of the investments will be redeemed at a future date for an amount different than the NAV of our ownership interest in partners' capital as of June 30, 2016 and December 31, 2015. During the six months ended June 30, 2016, no contributions were made and distributions totaling $0.7 million were received from these investments. During the year ended December 31, 2015, no contributions were made and distributions totaling $3.5 million were received from these investments. The amount of unfunded commitments related to the investments was $0.3 million as of June 30, 2016, and $0.6 million as of December 31, 2015.


11

Table of Contents

Level 3 Assets – Quarterly Change:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(in thousands)
 
 
Beginning balance at March 31, 2016
 
Included in
earnings (1)
 
Included
in other comprehensive
income
 
Purchases
 
Sales
 
Transfers
in and (out) of
Level 3
 
Ending balance at June 30, 2016
Available-for-sale securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
4,821

 
$
30

 
$
54

 
$
5,131

 
$
(551
)
 
$
(634
)
 
$
8,851

Commercial mortgage-backed securities
 
0

 
0

 
3

 
1,000

 
0

 
0

 
1,003

Collateralized debt obligations
 
12,037

 
0

 
0

 
1,200

 
0

 
(12,037
)
 
1,200

Total fixed maturities
 
16,858

 
30

 
57

 
7,331

 
(551
)
 
(12,671
)
 
11,054

Total available-for-sale securities
 
16,858

 
30

 
57

 
7,331

 
(551
)
 
(12,671
)
 
11,054

Total Level 3 assets
 
$
16,858

 
$
30

 
$
57

 
$
7,331

 
$
(551
)
 
$
(12,671
)
 
$
11,054


(1)
These amounts are reported in the Statement of Operations as net investment income and net realized investment gains (losses) for the three months ended June 30, 2016 on Level 3 securities.
 

We review the fair value hierarchy classifications each reporting period.  Transfers between hierarchy levels may occur due to changes in the available market observable inputs.  Transfers in and out of level classifications are reported as having occurred at the beginning of the quarter in which the transfers occurred.

There were no transfers between Level 1 and Level 2 for the three months ended June 30, 2016. Level 2 to Level 3 transfers totaled $1.7 million for seven fixed maturity holdings due to the use of unobservable market data to determine the fair value at June 30, 2016. Level 3 to Level 2 transfers totaled $14.3 million for 21 fixed maturity holdings due to the use of observable market data to determine the fair value at June 30, 2016.

Level 3 Assets – Year-to-Date Change:
 
(in thousands)
 
 
Beginning balance at December 31, 2015
 
Included in
earnings (1)
 
Included
in other comprehensive
income
 
Purchases
 
Sales
 
Transfers
in and (out) of
Level 3
 
Ending balance at June 30, 2016
Available-for-sale securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
69

 
$
45

 
$
81

 
$
8,670

 
$
(606
)
 
$
592

 
$
8,851

Commercial mortgage-backed securities
 
0

 
0

 
3

 
1,000

 
0

 
0

 
1,003

Collateralized debt obligations
 
8,577

 
4

 
(12
)
 
4,722

 
(54
)
 
(12,037
)
 
1,200

Total fixed maturities
 
8,646

 
49

 
72

 
14,392

 
(660
)
 
(11,445
)
 
11,054

Total available-for-sale securities
 
8,646

 
49

 
72

 
14,392

 
(660
)
 
(11,445
)
 
11,054

Total Level 3 assets
 
$
8,646

 
$
49

 
$
72

 
$
14,392

 
$
(660
)
 
$
(11,445
)
 
$
11,054

 
(1)
These amounts are reported in the Statement of Operations as net investment income and net realized investment gains (losses) for the six months ended June 30, 2016 on Level 3 securities.
 

There were no transfers between Level 1 and Level 2 for the six months ended June 30, 2016. Level 2 to Level 3 transfers totaled $3.0 million for 16 fixed maturity holdings due to the use of unobservable market data to determine the fair value at June 30, 2016. Level 3 to Level 2 transfers totaled $14.4 million for 22 fixed maturity holdings due to the use of observable market data to determine the fair value at June 30, 2016.


12

Table of Contents

Level 3 Assets – Quarterly Change:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(in thousands)
 
 
Beginning balance at March 31, 2015
 
Included in
earnings
 
Included
in other
comprehensive
income
 
Purchases
 
Sales
 
Transfers
in and (out) of
Level 3
 
Ending balance at June 30, 2015
Available-for-sale securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
110

 
$
0

 
$
0

 
$
0

 
$
0

 
$
(110
)
 
$
0

Collateralized debt obligations
 
0

 
0

 
0

 
660

 
0

 
0

 
660

Total fixed maturities
 
110

 
0

 
0

 
660

 
0

 
(110
)
 
660

Total available-for-sale securities
 
110

 
0

 
0

 
660

 
0

 
(110
)
 
660

Total Level 3 assets
 
$
110

 
$
0

 
$
0

 
$
660

 
$
0

 
$
(110
)
 
$
660



There were no transfers between Level 1 and Level 2 or from Level 2 to Level 3 for the three months ended June 30, 2015. Level 3 to Level 2 transfers totaled $0.1 million for one fixed maturity holding due to the use of observable market data to determine the fair value at June 30, 2015.

Level 3 Assets – Year-to-Date Change:
 
(in thousands)
 
 
Beginning balance at December 31, 2014
 
Included in
earnings
 
Included
in other
comprehensive
income
 
Purchases
 
Sales
 
Transfers
in and (out) of
Level 3
 
Ending balance at June 30, 2015
Available-for-sale securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
0

 
$
0

 
$
0

 
$
110

 
$
0

 
$
(110
)
 
$
0

Collateralized debt obligations
 
0

 
0

 
0

 
660

 
0

 
0

 
660

Total fixed maturities
 
0

 
0

 
0

 
770

 
0

 
(110
)
 
660

Total available-for-sale securities
 
0

 
0

 
0

 
770

 
0

 
(110
)
 
660

Total Level 3 assets
 
$
0

 
$
0

 
$
0

 
$
770

 
$
0

 
$
(110
)
 
$
660




There were no transfers between Level 1 and Level 2 or from Level 2 to Level 3 for the six months ended June 30, 2015. Level 3 to Level 2 transfers totaled $0.1 million for one fixed maturity holding due to the use of observable market data to determine the fair value at June 30, 2015.


13

Table of Contents

Quantitative and Qualitative Disclosures about Unobservable Inputs

When a non-binding broker quote was the only input available, the security was classified within Level 3. Use of non-binding brokers quotes totaled $11.1 million at June 30, 2016. The unobservable inputs are not reasonably available to us.

The following table presents our fair value measurements on a recurring basis by pricing source:
 
(in thousands)
 
At June 30, 2016
 
 
Total
 
Level 1
 
Level 2
 
Level 3
Fixed maturities:
 
 
 
 
 
 
 
 
Priced via pricing services
 
$
642,318

 
$
0

 
$
633,467

 
$
8,851

Priced via market comparables/broker quotes
 
2,203

 
0

 
0

 
2,203

Total fixed maturities
 
644,521

 
0

 
633,467

 
11,054

Common stock:
 
 
 
 
 
 
 
 
Priced via pricing services
 
9,610

 
9,610

 
0

 
0

Total common stock
 
9,610

 
9,610

 
0

 
0

Other investments:
 
 
 
 
 
 
 
 
Priced via unobservable inputs (1)
 
3,908

 

 

 

Total other investments
 
3,908

 

 

 

Total
 
$
658,039

 
$
9,610

 
$
633,467

 
$
11,054

 


(1)
Other investments measured at fair value represent real estate funds included on the balance sheet as limited partnership investments that are reported under the fair value option using the net asset value practical expedient. These amounts are not required to be categorized in the fair value hierarchy. The fair value of these investments is based on the net asset value (NAV) information provided by the general partner.

 
There were no assets measured at fair value on a nonrecurring basis during the six months ended June 30, 2016.



14

Table of Contents

Note 5.  Investments
 
Available-for-sale securities
The following table summarizes the cost and fair value of our available-for-sale securities:
 
 
 
At June 30, 2016
 (in thousands)
 
Amortized
cost
 
Gross unrealized gains
 
Gross unrealized losses
 
Estimated fair value
Available-for-sale securities:
 
 
 
 
 
 
 
 
States & political subdivisions
 
$
227,669

 
$
14,155

 
$
0

 
$
241,824

Corporate debt securities
 
288,887

 
2,361

 
1,220

 
290,028

Residential mortgage-backed securities
 
14,125

 
43

 
139

 
14,029

Commercial mortgage-backed securities
 
40,503

 
292

 
772

 
40,023

Collateralized debt obligations
 
56,761

 
104

 
232

 
56,633

Other debt securities
 
2,000

 
0

 
16

 
1,984

Total fixed maturities
 
629,945

 
16,955

 
2,379

 
644,521

Common stock
 
8,949

 
165

 
0

 
9,114

Total available-for-sale securities
 
$
638,894

 
$
17,120

 
$
2,379

 
$
653,635

 

 
 
At December 31, 2015
(in thousands)
 
Amortized
cost
 
Gross unrealized gains
 
Gross unrealized losses
 
Estimated fair value
Available-for-sale securities:
 
 
 
 
 
 
 
 
States & political subdivisions
 
$
221,093

 
$
10,761

 
$
7

 
$
231,847

Corporate debt securities
 
254,464

 
281

 
4,412

 
250,333

Residential mortgage-backed securities
 
13,639

 
4

 
130

 
13,513

Commercial mortgage-backed securities
 
38,630

 
30

 
1,089

 
37,571

Collateralized debt obligations
 
51,905

 
61

 
221

 
51,745

Other debt securities
 
2,241

 
0

 
41

 
2,200

Total fixed maturities
 
581,972

 
11,137

 
5,900

 
587,209

Common stock
 
12,865

 
0

 
133

 
12,732

Total available-for-sale securities
 
$
594,837

 
$
11,137

 
$
6,033

 
$
599,941

 
 
The amortized cost and estimated fair value of fixed maturities at June 30, 2016 are shown below by remaining contractual term to maturity.  Mortgage-backed securities are allocated based upon their stated maturity dates.  Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
 
 
 
At June 30, 2016
(in thousands)
 
Amortized
 
Estimated
 
 
cost
 
fair value
Due in one year or less
 
$
45,685

 
$
45,799

Due after one year through five years
 
296,550

 
300,336

Due after five years through ten years
 
188,270

 
195,896

Due after ten years
 
99,440

 
102,490

Total fixed maturities
 
$
629,945

 
$
644,521




15

Table of Contents

Available-for-sale securities in a gross unrealized loss position are as follows.  Data is provided by length of time for securities in a gross unrealized loss position.
 
 
 
At June 30, 2016
(dollars in thousands)
 
Less than 12 months
 
12 months or longer
 
Total
 
 
Fair
value
 
Unrealized losses
 
Fair
value
 
Unrealized losses
 
Fair
 value
 
Unrealized losses
 
No. of holdings
Available-for-sale securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate debt securities
 
65,341

 
666

 
21,953

 
554

 
87,294

 
1,220

 
260

Residential mortgage-backed securities
 
5,051

 
18

 
2,599

 
121

 
7,650

 
139

 
7

Commercial mortgage-backed securities
 
1,283

 
7

 
17,931

 
765

 
19,214

 
772

 
18

Collateralized debt obligations
 
19,843

 
118

 
13,681

 
114

 
33,524

 
232

 
17

Other debt securities
 
0

 
0

 
1,984

 
16

 
1,984

 
16

 
1

Total fixed maturities
 
91,518

 
809

 
58,148

 
1,570

 
149,666

 
2,379

 
303

Total available-for-sale securities
 
$
91,518

 
$
809

 
$
58,148

 
$
1,570

 
$
149,666

 
$
2,379

 
303

Quality breakdown of fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Investment grade
 
$
42,174

 
$
170

 
$
47,584

 
$
1,069

 
$
89,758

 
$
1,239

 
56

Non-investment grade
 
49,344

 
639

 
10,564

 
501

 
59,908

 
1,140

 
247

Total fixed maturities
 
$
91,518

 
$
809

 
$
58,148

 
$
1,570

 
$
149,666

 
$
2,379

 
303



 
 
At December 31, 2015
(dollars in thousands)
 
Less than 12 months
 
12 months or longer
 
Total
 
 
Fair
value
 
Unrealized
losses
 
Fair
value
 
Unrealized
losses
 
Fair
value
 
Unrealized
losses
 
No. of
holdings
Available-for-sale securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
States & political subdivisions
 
$
5,867

 
$
7

 
$
0

 
$
0

 
$
5,867

 
$
7

 
3

Corporate debt securities
 
172,831

 
2,447

 
19,086

 
1,965

 
191,917

 
4,412

 
349

Residential mortgage-backed securities
 
9,827

 
84

 
936

 
46

 
10,763

 
130

 
9

Commercial mortgage-backed securities
 
13,081

 
68

 
19,081

 
1,021

 
32,162

 
1,089

 
24

Collateralized debt obligations
 
27,981

 
103

 
9,174

 
118

 
37,155

 
221

 
19

Other debt securities
 
1,960

 
40

 
241

 
1

 
2,201

 
41

 
2

Total fixed maturities
 
231,547

 
2,749

 
48,518

 
3,151

 
280,065

 
5,900

 
406

Common stock
 
12,732

 
133

 
0

 
0

 
12,732

 
133

 
1

Total available-for-sale securities
 
$
244,279

 
$
2,882

 
$
48,518

 
$
3,151

 
$
292,797

 
$
6,033

 
407

Quality breakdown of fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Investment grade
 
$
174,723

 
$
1,296

 
$
38,369

 
$
1,256

 
$
213,092

 
$
2,552

 
105

Non-investment grade
 
56,824

 
1,453

 
10,149

 
1,895

 
66,973

 
3,348

 
301

Total fixed maturities
 
$
231,547

 
$
2,749

 
$
48,518

 
$
3,151

 
$
280,065

 
$
5,900

 
406

 
 
The above securities have been evaluated and determined to be temporary impairments for which we expect to recover our entire principal plus interest.  The primary components of this analysis include a general review of market conditions and financial performance of the issuer along with the extent and duration at which fair value is less than cost.  Any securities that we intend to sell or will more likely than not be required to sell before recovery are included in other-than-temporary impairments with the impairment charges recognized in earnings.


16

Table of Contents

Net investment income
Interest and dividend income are recognized as earned and recorded to net investment income.  Investment income, net of expenses, was generated from the following portfolios:

(in thousands)
 
Three months ended June 30,
 
Six months ended June 30,
 
 
2016
 
2015
 
2016
 
2015
Fixed maturities
 
$
4,858

 
$
4,150

 
$
9,384

 
$
8,229

Equity securities
 
47

 
240

 
82

 
500

Cash equivalents and other
 
321

 
281

 
645

 
575

Total investment income
 
5,226

 
4,671

 
10,111

 
9,304

Less: investment expenses
 
335

 
236

 
558

 
328

Net investment income
 
$
4,891

 
$
4,435

 
$
9,553

 
$
8,976

 
 
Realized investment gains (losses)
Realized gains and losses on sales of securities are recognized in income based upon the specific identification method. Realized gains (losses) on investments were as follows:

(in thousands)
 
Three months ended June 30,
 
Six months ended June 30,
 
 
2016
 
2015
 
2016
 
2015
Available-for-sale securities:
 
 

 
 

 
 

 
 

Fixed maturities:
 
 

 
 

 
 

 
 

Gross realized gains
 
$
438

 
$
340

 
$
572

 
$
371

Gross realized losses
 
(209
)
 
(104
)
 
(1,792
)
 
(375
)
Net realized gains (losses)
 
229

 
236

 
(1,220
)
 
(4
)
Equity securities:
 


 
 

 
 

 
 

Gross realized gains
 
0

 
362

 
0

 
362

Gross realized losses
 
0

 
0

 
(34
)
 
0

Net realized gains (losses)
 
0

 
362

 
(34
)
 
362

Trading securities:
 


 
 

 
 

 
 

Common stock:
 


 
 

 
 

 
 

Gross realized gains
 
586

 
0

 
586

 
0

Gross realized losses
 
0

 
0

 
0

 
0

Decreases in fair value(1)
 
(416
)
 
0

 
(21
)
 
0

Net realized gains
 
170

 
0

 
565

 
0

Net realized investment gains (losses)
 
$
399

 
$
598

 
$
(689
)
 
$
358


 
(1)
The fair