Erie Indemnity Company 10-K
 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
[X]  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2007
OR
[    ]   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
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 incorporation or organization)
  (I.R.S. Employer
Identification No.)
     
100 Erie Insurance Place, Erie, Pennsylvania   16530
 
 
 
(Address of principal executive offices)   (Zip code)
(814) 870-2785
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:

     
Class A Common Stock, stated value $0.0292 per share,
Class B Common Stock, stated value $70 per share
 
 
listed on the NASDAQ Stock Market, LLC

     
(Title of each class)   (Name of each exchange on which registered)
Securities registered pursuant to Section 12(g) of the Act: None
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 if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes                   No      X     
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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.   [   ]
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 Act). Yes                   No      X     
Aggregate market value of voting stock held by non-affiliates: There is no active market for the Class B voting stock. The Class B stock is closely held by few shareholders.
Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date: 52,782,002 shares of Class A Common Stock and 2,551 shares of Class B Common Stock outstanding on February 15, 2008.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant’s Proxy Statement relating to the Annual Meeting of Shareholders to be held April 22, 2008 are incorporated by reference into Part III of this Form 10-K Report.

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INDEX
                 
PART  
ITEM NUMBER AND CAPTION
  PAGE
 
               
  Item 1.   Business     3  
 
  Item 1A.   Risk Factors     8  
 
  Item 1B.   Unresolved Staff Comments     12  
 
  Item 2.   Properties     12  
 
  Item 3.   Legal Proceedings     12  
 
  Item 4.   Submission of Matters to a Vote of Security Holders     13  
 
               
  Item 5.   Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities     14  
 
  Item 6.   Selected Consolidated Financial Data     16  
 
  Item 7.   Management’s Discussion and Analysis of Financial Condition and Results of Operations     17  
 
  Item 7A.   Quantitative and Qualitative Disclosures About Market Risk     44  
 
  Item 8.   Financial Statements and Supplementary Data     47  
 
  Item 9.   Changes In and Disagreements With Accountants on Accounting and Financial Disclosure     99  
 
  Item 9A.   Controls and Procedures     99  
 
  Item 9B.   Other Information     99  
 
               
  Item 10.   Directors, Executive Officers and Corporate Governance     100  
 
  Item 11.   Executive Compensation     101  
 
  Item 12.   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters     101  
 
  Item 13.   Certain Relationships and Related Transactions, and Director Independence     101  
 
  Item 14.   Principal Accountant Fees and Services     101  
 
               
  Item 15.   Exhibits and Financial Statement Schedules     102  
 
               
 
      Signatures     103  

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PART I
Item 1. Business
General
Erie Indemnity Company (Company), a Pennsylvania corporation, operates predominantly as the management services company that provides sales, underwriting and policy issuance services to the policyholders of Erie Insurance Exchange (Exchange). The Exchange is a reciprocal insurance exchange, which is an unincorporated association of individuals, partnerships and corporations that agree to insure one another. Each applicant for insurance to a reciprocal insurance exchange signs a subscriber’s agreement that contains an appointment of an attorney-in-fact. We have served as the attorney-in-fact for the policyholders of the Exchange since 1925. We also operate as a property/casualty insurer through our three wholly-owned subsidiaries, Erie Insurance Company, Erie Insurance Property and Casualty Company and Erie Insurance Company of New York. The Exchange and its property/casualty insurance subsidiary, Flagship City Insurance Company, and our three insurance subsidiaries (collectively, the Property and Casualty Group) write a broad line of personal and commercial lines property and casualty coverages and pool their underwriting results. Our financial position or results of operations are not consolidated with the Exchange’s. We also own 21.6% of the common stock of Erie Family Life Insurance Company (EFL), an affiliated life insurance company of which the Exchange owns 78.4%. We, together with our subsidiaries, affiliates and the Exchange operate collectively as the Erie Insurance Group.
Business segments
We operate our business as three reportable segments — management operations, insurance underwriting operations and investment operations. Financial information about these segments is set forth in and referenced to Item 8. “Financial Statements and Supplementary Data — Note 20 of Notes to Consolidated Financial Statements” contained within this report. Further discussion of financial results by operating segment is provided in and referenced to Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contained within this report.
Description of business
For our services as attorney-in-fact, we charge the Exchange a management fee of up to 25% of the direct written premiums of the Property and Casualty Group. Management fees accounted for approximately 72% of our revenues in 2007, 2006 and 2005.
We have an interest in the growth and financial condition of the Exchange as 1) the Exchange is our sole customer and 2) our earnings are largely generated from management fees based on the direct written premium of the Exchange and other members of the Property and Casualty Group. The Property and Casualty Group operates as a regional insurance carrier that underwrites a broad range of personal and commercial insurance using its non-exclusive independent agency force as its sole distribution channel. In addition to their principal role as salespersons, the independent agents play a significant role as underwriting and service providers and are fundamental to the Property and Casualty Group’s success. The Property and Casualty Group is represented by nearly 2,000 independent agencies comprising over 8,400 licensed representatives. The Property and Casualty Group operates primarily in the Midwest, mid-Atlantic and southeast regions of the United States (Illinois, Indiana, Maryland, New York, North Carolina, Ohio, Pennsylvania, Tennessee, Virginia, West Virginia and Wisconsin and the District of Columbia). Pennsylvania, Maryland and Virginia made up 65% of the Property and Casualty Group’s 2007 direct written premium. We intend to begin writing in the state of Minnesota in 2009. While sales, underwriting and policy issuance services are centralized at our home office, the Property and Casualty Group maintains 23 field offices throughout its operating region to provide claims services to policyholders and marketing support for the independent agents who represent us.
Historically, due to policy renewal and sales patterns, the Property and Casualty Group’s direct written premiums are greater in the second and third quarters of the calendar year. Consequently, we generate more management fee and have higher gross margins in our management operations in those quarters. While loss and loss adjustment expenses are not entirely predictable, historically such costs have been greater during the third and fourth quarters, influenced by the weather in the geographic regions, including the Midwest, mid-Atlantic and southeast regions in which the Property and Casualty Group operates.
The members of the Property and Casualty Group pool their underwriting results. Under the pooling arrangement, the Exchange assumes 94.5% of the pool. Accordingly, the underwriting risk of the Property and Casualty Group’s

3


 

business is largely borne by the Exchange, which had $4.8 billion and $4.1 billion of statutory surplus at December 31, 2007 and 2006, respectively. Through the pool, our property/casualty insurance subsidiaries currently assume 5.5% of the Property and Casualty Group’s underwriting results, and, therefore, we also have a direct incentive to manage the insurance underwriting operations as effectively as possible.
Principal products
The Property and Casualty Group seeks to insure standard and preferred risks primarily in personal and commercial lines. In 2007, personal lines comprised 70% of direct written premium revenue of the Property and Casualty Group while commercial lines made up the remaining 30%.
The principal products in personal lines, based upon direct written premiums, are private passenger automobile (47%) and homeowners (20%) while the principal commercial lines consist of multi-peril (12%), commercial automobile (9%) and workers compensation (7%).
Competition
Property and casualty insurers generally compete on the basis of customer service, price, brand recognition, coverages offered, claim handling ability, financial stability and geographic coverage. Vigorous competition, particularly in the personal lines automobile and homeowners lines of business, is provided by large, well-capitalized national companies, some of which have broad distribution networks of employed or captive agents, by smaller regional insurers and by large companies who market and sell personal lines products directly to consumers. In addition, because the insurance products of the Property and Casualty Group are marketed exclusively through independent insurance agents, the Property and Casualty Group faces competition within its appointed agencies based on ease of doing business, product, price and service relationships. The market is competitive with some carriers filing rate decreases while others focus on acquiring business through other means, such as increases in advertising and effective utilization of technology. Some carriers have increased their spending on advertising in an effort to generate increased sales and market penetration. The Property and Casualty Group ranked as the 16th largest automobile insurer in the United States based on 2006 direct written premiums and as the 21st largest property/casualty insurer in the United States based on 2006 total lines net premium written according to AM Best.
Market competition bears directly on the price charged for insurance products and services subject to regulatory limitations. Growth is driven by a company’s ability to provide insurance services and competitive prices while maintaining target profit margins and is influenced by capital adequacy. Industry capital levels can also significantly affect prices charged for coverage. Growth is a product of a company’s ability to retain existing customers and to attract new customers, as well as movement in the average premium per policy.
The Erie Insurance Group has followed several strategies that we believe will result in long-term underwriting performance which exceeds those of the property/casualty industry in general. First, the Erie Insurance Group employs an underwriting philosophy and product mix targeted to produce a Property and Casualty Group underwriting profit on a long-term basis through careful risk selection and rational pricing. The careful selection of risks allows for lower claims frequency and loss severity, thereby enabling insurance to be offered at favorable prices. The Property and Casualty Group has continued to refine its risk measurement and price segmentation model used in the underwriting and pricing processes. Second, the Property and Casualty Group focuses on consistently providing superior service to policyholders and agents. Third, the Property and Casualty Group’s business model is designed to provide the advantages of localized marketing and claims servicing with the economies of scale and low cost of operations from centralized accounting, administrative, underwriting, investment, information management and other support services.
Finally, we carefully select the independent agencies that represent the Property and Casualty Group. The Property and Casualty Group seeks to be the lead insurer with its agents in order to enhance the agency relationship and the likelihood of receiving the most desirable underwriting opportunities from its agents. We have ongoing, direct communications with the agency force. Agents have access to a number of venues we sponsor designed to promote sharing of ideas, concerns and suggestions with the senior management of the Property and Casualty Group with the goal of improving communications and service. We continue to evaluate new ways to support our agents’ efforts, from marketing programs to identifying potential customer leads, to grow the business of the Property and Casualty Group. These efforts have resulted in outstanding agency penetration and the ability to sustain long-term agency partnerships. The higher agency penetration and long-term relationships allow for greater efficiency in providing agency support and training.

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Employees
We employed just over 4,100 people at December 31, 2007, of which approximately 2,100 provide claims specific services exclusively for the Property and Casualty Group and 80 perform services exclusively for EFL. Both the Exchange and EFL reimburse us at least quarterly for the cost of these services.
Reserves for losses and loss adjustment expenses
The following table illustrates the change over time of the loss and loss adjustment expense reserves established for our property/casualty insurance subsidiaries at the end of the last ten calendar years. The development of loss and loss adjustment expenses are presented on a gross basis (gross of ceding transactions in the intercompany pool) and a net basis (the amount remaining as our exposure after ceding and assuming amounts through the intercompany pool as well as transactions under the excess-of-loss reinsurance agreement with the Exchange). However, incurred but not reported reserves are developed for the Property and Casualty Group as a whole and then allocated to members of the Property and Casualty Group based on each member’s proportionate share of earned premiums. We do not develop IBNR reserves for each of the property/casualty insurance subsidiaries based on their direct and assumed writings. Consequently, the gross liability data contained in this table does not accurately reflect the underlying reserve development of our property/casualty insurance subsidiaries.
Our 5.5% share of the loss and loss adjustment expense reserves of the Property and Casualty Group are shown in the net presentation and are more representative of the actual development of the property/casualty insurance losses accruing to our subsidiaries. The gross presentation is shown to be consistent with the balance sheet presentation of reinsurance transactions which requires direct and ceded amounts to be presented separate from one another, in accordance with FAS 113, “Accounting and Reporting for Reinsurance of Short Duration and Long Duration Contracts”, thus the gross liability for unpaid losses and LAE of $1,026.5 million at December 31, 2007 agrees to the gross balance sheet amount. However, factoring in the reinsurance recoverables of $834.4 million at December 31, 2007 presented in the balance sheet the net obligation to us is $192.1 million at December 31, 2007. Additional discussion of our reserve methodology can be found in and is referenced to Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Estimates” contained within this report.
                                                                                 
    Property and Casualty Subsidiaries of Erie Indemnity Company  
    Reserves for Unpaid Losses and Loss Adjustment Expenses (LAE)  
                                    At December 31,                          
 
                                                                               
(amounts in millions)   1998     1999     2000     2001     2002     2003     2004     2005     2006     2007  
 
                                                                               
Gross liability for unpaid losses and loss adjustment expenses
  $426.2     $432.9     $477.9     $557.3     $717.0     $845.5     $943.0     $1,019.5     $1,073.6     $1,026.5  
 
                                                                               
Gross liability re-estimated as of:
                                                                               
One year later
    431.2       477.0       516.2       622.6       727.2       832.2       927.5       980.3       986.0          
 
                                                                             
 
                                                                               
Two years later
    448.7       487.2       567.1       635.1       736.3       843.3       935.6       929.8                  
 
                                                                             
 
                                                                               
Three years later
    453.3       518.6       567.2       649.1       755.5       880.2       906.0                          
 
                                                                             
 
                                                                               
Four years later
    471.9       518.5       588.7       669.9       767.8       850.8                                  
 
                                                                             
 
                                                                               
Five years later
    472.2       541.1       619.0       713.1       770.1                                          
 
                                                                             
 
                                                                               
Six years later
    492.3       568.9       642.1       691.0                                                  
 
                                                                             
 
                                                                               
Seven years later
    516.4       616.6       640.0                                                          
 
                                                                             
 
                                                                               
Eight years later
    545.8       590.4                                                                  
 
                                                                             
 
                                                                               
Nine years later
    534.1                                                                          
 
                                                                             
 
                                                                               
Cumulative (deficiency) redundancy
    (107.9 )     (157.5 )     (162.1 )     (133.7 )     (53.1 )     (5.3 )     37.0       89.7       87.6          
 
                                                             
 
                                                                               
Gross liability for unpaid losses and LAE
  $426.2     $432.9     $477.9     $557.3     $717.0     $845.5     $943.0     $1,019.5     $1,073.6     $1,026.5  
 
                                                                               
Reinsurance recoverable on unpaid losses
    334.8       337.9       375.6       438.6       577.9       687.8       765.6       828.0       873.0       834.4  
 
                                                           
 
                                                                               
Net liability for unpaid losses and LAE
    $91.4       $95.0       $102.3       $118.7       $139.1       $157.7       $177.4       $191.5       $200.6       $192.1  
 
                                                           

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    Reserves for Unpaid Losses and Loss Adjustment Expenses (Continued)  
    At December 31,  
(amounts in millions)   1998     1999     2000     2001     2002     2003     2004     2005     2006     2007  
 
                                                                               
Net re-estimated liability as of:
                                                                               
One year later
  $92.5     $104.7     $109.8     $126.6     $140.9     $162.6     $181.2     $183.0       $184.8          
 
                                                                             
 
                                                                               
Two years later
    96.2       106.2       116.0       127.0       144.6       171.9       179.3       183.8                  
 
                                                                             
 
                                                                               
Three years later
    97.2       110.6       116.2       131.9       155.7       173.8       181.2                          
 
                                                                             
 
                                                                               
Four years later
    101.2       110.8       120.9       143.6       157.6       181.4                                  
 
                                                                             
 
                                                                               
Five years later
    101.3       115.3       132.5       146.2       166.7                                          
 
                                                                             
 
                                                                               
Six years later
    105.6       124.8       135.0       156.2                                                  
 
                                                                             
 
                                                                               
Seven years later
    110.8       126.7       137.0                                                          
 
                                                                             
 
                                                                               
Eight years later
    113.2       129.6                                                                  
 
                                                                             
 
                                                                               
Nine years later
    114.5                                                                          
 
                                                                             
 
                                                                               
Cumulative (deficiency) redundancy
    $(23.1 )     $(34.6 )     $(34.7 )     $(37.5 )     $(27.6 )     $(23.7 )     $(3.8 )     $7.7       $15.8          
 
                                                             

                                                                                 
(amounts in millions)   1998     1999     2000     2001     2002     2003     2004     2005     2006     2007  
Cumulative amount of gross liability paid through:
                                                                               
One year later
  $ 145.4     $ 158.9     $ 174.4     $ 194.3     $ 217.0     $ 259.1     $ 271.4     $ 292.4     $ 279.1          
 
                                                                             
 
                                                                               
Two years later
    228.2       244.9       270.9       302.1       351.0       410.6       423.1       424.6                  
 
                                                                             
 
                                                                               
Three years later
    274.9       297.6       326.1       372.5       434.7       493.7       495.6                          
 
                                                                             
 
                                                                               
Four years later
    300.9       326.9       361.3       418.9       461.9       514.8                                  
 
                                                                             
 
                                                                               
Five years later
    315.8       347.0       384.8       440.9       479.3                                          
 
                                                                             
 
                                                                               
Six years later
    325.9       362.9       384.4       436.5                                                  
 
                                                                             
 
                                                                               
Seven years later
    336.6       387.6       406.3                                                          
 
                                                                             
 
                                                                               
Eight years later
    352.6       399.6                                                                  
 
                                                                             
 
                                                                               
Nine years later
    358.1                                                                          
 
                                                                             
Cumulative amount of net liability paid through:
                                                                               
One year later
  $33.6     $38.9     $41.2     $47.3     $50.5     $58.5     $54.5     $58.7     $56.0          
 
                                                                             
 
                                                                               
Two years later
    52.4       59.2       64.9       72.9       80.9       86.7       89.3       89.6                  
 
                                                                             
 
                                                                               
Three years later
    63.9       73.5       78.5       91.0       95.5       108.5       108.9                          
 
                                                                             
 
                                                                               
Four years later
    71.3       80.8       88.3       97.8       107.8       120.1                                  
 
                                                                             
 
                                                                               
Five years later
    74.9       86.7       91.7       105.1       114.3                                          
 
                                                                             
 
                                                                               
Six years later
    78.4       90.6       96.0       109.0                                                  
 
                                                                             
 
                                                                               
Seven years later
    81.4       93.7       98.2                                                          
 
                                                                             
 
                                                                               
Eight years later
    84.1       95.3                                                                  
 
                                                                             
 
                                                                               
Nine years later
    85.3                                                                          
 
                                                                             
The Property and Casualty Group discounts only workers’ compensation reserves. These reserves are discounted on a nontabular basis as prescribed by the Insurance Department of the Commonwealth of Pennsylvania. The interest rate of 2.5% used to discount these reserves is based upon the Property and Casualty Group’s historical workers’ compensation payout pattern. Our unpaid losses and loss adjustment expenses reserve was reduced by $5.5 million and $5.0 million at December 31, 2007 and 2006, respectively, as a result of this discounting.
A reconciliation of our property/casualty insurance subsidiaries’ claims reserves can be found in Item 8. “Financial Statements and Supplementary Data - Note 12 of Notes to Consolidated Financial Statements” contained within this report. Additional discussion of reserve activity can be found in and is referenced to Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition” section contained within this report.

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Government Regulation
The Property and Casualty Group is subject to supervision and regulation in the states in which it transacts business. The primary purpose of such supervision and regulation is the protection of policyholders. The extent of such regulation varies, but generally derives from state statutes that delegate regulatory, supervisory and administrative authority to state insurance departments. Accordingly, the authority of the state insurance departments includes the establishment of standards of solvency that must be met and maintained by insurers, the licensing to do business of insurers and agents, the nature of the limitations on investments, the approval of premium rates for property/casualty insurance, the provisions that insurers must make for current losses and future liabilities, the deposit of securities for the benefit of policyholders, the approval of policy forms, notice requirements for the cancellation of policies and the approval of certain changes in control. In addition, many states have enacted variations of competitive rate-making laws that allow insurers to set certain premium rates for certain classes of insurance without having to obtain the prior approval of the state insurance department. State insurance departments also conduct periodic examinations of the affairs of insurance companies and require the filing of quarterly and annual reports relating to the financial condition of insurance companies.
The Property and Casualty Group is also required to participate in various involuntary insurance programs for automobile insurance, as well as other property/casualty lines, in states in which such companies operate. These involuntary programs provide various insurance coverages to individuals or other entities that otherwise are unable to purchase such coverage in the voluntary market. These programs include joint underwriting associations, assigned risk plans, fair access to insurance requirements (“FAIR”) plans, reinsurance facilities and windstorm plans. Legislation establishing these programs generally provides for participation in proportion to voluntary writings of related lines of business in that state. The loss ratio on insurance written under involuntary programs has traditionally been greater than the loss ratio on insurance in the voluntary market. Involuntary programs generated underwriting gains of $15.0 million for the Property and Casualty Group in 2007, compared to gains of $1.9 million in 2006, and losses, primarily from hurricanes in states supported by these programs, of $12.5 million in 2005. Our share of these underwriting gains related to involuntary programs was $0.8 million in 2007 and $.1 million in 2006, compared to our share of losses in 2005 of $0.7 million.
Most states have enacted legislation that regulates insurance holding company systems such as the Erie Insurance Group. Each insurance company in the holding company system is required to register with the insurance supervisory authority of its state of domicile and furnish information regarding the operations of companies within the holding company system that may materially affect the operations, management or financial condition of the insurers within the system. Pursuant to these laws, the respective insurance departments may examine us and the Property and Casualty Group at any time, require disclosure of material transactions with the insurers and us as an insurance holding company and require prior approval of certain transactions between the Property and Casualty Group and us.
All transactions within the holding company system affecting the insurers we manage are filed with the applicable insurance departments and must be fair and reasonable. Approval of the applicable insurance commissioner is required prior to the consummation of transactions affecting the control of an insurer. In some states, the acquisition of 10% or more of the outstanding common stock of an insurer or its holding company is presumed to be a change in control.
Website access
Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports are available free of charge on our website at www.erieinsurance.com as soon as reasonably practicable after such material is filed electronically with the SEC. Our Code of Conduct is available on our website and in printed form upon request. Our proxy statement and annual report on Form 10-K are also available free of charge at www.erieindemnityproxy.com. Copies of our annual report on Form 10-K will be made available, free of charge, upon written request as well.

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Item 1A. Risk Factors
Our business involves various risks and uncertainties, including, but not limited to those discussed in this section. The events described in the risk factors below, or any additional risk outside of those discussed below, could have a material adverse effect on our business, financial condition, operating results or liquidity if they actually occur. This information should be considered carefully together with the other information contained in this report, including management’s discussion and analysis of financial condition and results of operations, the consolidated financial statements and the related notes.
We have developed a formal Enterprise Risk Management (ERM) function that is responsible for developing processes and infrastructure for managing enterprise risk within our risk tolerances. Our ERM committee is a cross-functional team of senior management across all major business functions of the enterprise, which is responsible for risk quantification and identification on an integrated basis. The ERM committee has established the framework, principles and guidelines for our ERM program so that aggregated risks do not result in levels of risk that are unacceptable to the Company or any of its subsidiaries or affiliates, including the Erie Insurance Exchange.
An essential part of our ERM infrastructure is a stochastic modeling capability for our property/casualty insurance operations as well as the investment operations of the Property and Casualty Group. The modeling capability has been in use for a number of years and is a significant component in our quantification of insurance and investment risk. The model is used in our assessment of the variability of risk inherent in our operations and the sufficiency of enterprise capital levels given our defined tolerance for risk. The model is used to provide additional insights into capital management, strategic asset allocation of our investment portfolios, capital required for product lines sold by the enterprise, catastrophe exposure management and reinsurance purchasing and risk mitigation strategy.
Risk factors related to our business and relationships with third parties
If the management fee rate paid by the Exchange is reduced, if there is a significant decrease in the amount of premiums written by the Exchange, or if the costs of providing services to the Exchange are not controlled, revenues and profitability could be materially adversely affected.
We are dependent upon management fees paid by the Exchange, which represent our principal source of revenue. Management fee revenue from the Exchange is calculated by multiplying the management fee rate by the direct premiums written by the Exchange and the other members of the Property and Casualty Group, which are assumed by the Exchange under an intercompany pooling arrangement. Accordingly, any reduction in direct premiums written by the Property and Casualty Group would have a proportional negative effect on our revenues and net income. See the “Risk Factors relating to the business of the Property and Casualty Group” section, herein, for a discussion of risks impacting direct written premium.
The management fee rate is determined by the Board of Directors and may not exceed 25% of the direct written premiums of the Property and Casualty Group. The Board of Directors sets the management fee rate each December for the following year. At their discretion, the rate can be changed at any time, but such changes would only be made in response to unusual circumstances. The factors considered by the Board in setting the management fee rate include our financial position in relation to the Exchange and the long-term needs of the Exchange for capital and surplus to support its continued growth and competitiveness. If the Board of Directors determines that the management fee rate should be reduced, our revenues and profitability could be materially adversely affected.
Pursuant to the attorney-in-fact agreements with the policyholders of the Exchange, we are appointed to perform certain services, regardless of the cost to us of providing those services. These services relate to the sales, underwriting and issuance of policies on behalf of the Exchange. We would lose money or be less profitable if the cost of providing those services increases significantly.
We are subject to credit risk from the Exchange because the management fees from the Exchange are not paid immediately when earned. Our property/casualty insurance subsidiaries are subject to credit risk from the Exchange because the Exchange assumes a higher insurance risk under an intercompany reinsurance pooling arrangement than is proportional to its direct business contribution to the pool.
We recognize management fees due from the Exchange as income when the premiums are written because at that time we have performed substantially all of the services we are required to perform, including sales, underwriting

8


 

and policy issuance activities. However, such fees are not paid to us by the Exchange until the Exchange collects the premiums from policyholders. As a result, we hold receivables for management fees earned and due us.
Two of our wholly-owned property/casualty insurance subsidiaries, Erie Insurance Company and Erie Insurance Company of New York, are parties to the intercompany pooling arrangement with the Exchange. Under this pooling arrangement, our insurance subsidiaries cede 100% of their property/casualty underwriting business to the Exchange, which retrocedes 5% of the pooled business to Erie Insurance Company and 0.5% to Erie Insurance Company of New York. In 2007, approximately 83% of the pooled direct property/casualty business was originally generated by the Exchange and its subsidiary, while 94.5% of the pooled business is retroceded to the Exchange under the intercompany pooling arrangement. Accordingly, the Exchange assumes a higher insurance risk than is proportional to the insurance business it contributes to the pool. This poses a credit risk to our property/casualty subsidiaries participating in the pool as they retain the responsibility to their direct policyholders if the Exchange is unable to meet its reinsurance obligations.
We hold receivables from the Exchange for costs we pay on the Exchange’s behalf and for reinsurance under the intercompany pooling arrangement. Our total receivable from the Exchange, including the management fee, reimbursable costs we paid on behalf of the Exchange and total amounts recoverable from the intercompany reinsurance pool, totaled $1.2 billion or 40.0% of our total assets at December 31, 2007.
Our financial condition may suffer because of declines in the value of the securities held in our investment portfolio that constitute a significant portion of our assets.
During the second half of 2007, the credit markets were extremely volatile, initially triggered by valuation issues affecting asset-backed and mortgage-backed securities, with a concentration in subprime mortgage structured products. Credit market instability spread to the financial services sector amid concerns about that sector’s exposure to real estate related structured products. Certain financial markets remain significantly disrupted and the potential for reduced liquidity and credit quality remains a risk to our fixed income portfolio. While our fixed income portfolio is well diversified, continued volatility in the credit markets could adversely affect the values and liquidity of our corporate and municipal bonds and our asset-backed and mortgage-backed securities, which could have a material adverse affect on our financial condition. We do not hedge our exposure to interest rate risk as we have the ability to hold fixed income securities to maturity. Our 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. We do not hedge our exposure to credit risk as we control industry and issuer exposure in our diversified portfolio.
At December 31, 2007, we had investments in equity securities of $218 million and investments in limited partnerships of $293 million, or 7.6% and 10.2% of total assets, respectively. In addition, we are obligated to invest up to an additional $148 million in limited partnerships, including private equity, real estate and fixed income partnership investments. Limited partnerships are less liquid and involve higher degrees of price risk than publicly traded securities. Limited partnerships, like publicly traded securities, have exposure to market volatility; but unlike publicly traded securities, cash flows and return expectations are less predictable.
All of our marketable securities are subject to market volatility. Our marketable securities have exposure to price risk and the volatility of the equity markets and general economic conditions. To the extent that future market volatility negatively impacts our investments, our financial condition will be negatively impacted. We review the investment portfolio on a continuous basis to evaluate positions that might have incurred other-than-temporary declines in value. The primary factors considered in our review of investment valuation include the extent and duration to which fair value is less than cost, historical operating performance and financial condition of the issuer, short- and long-term prospects of the issuer and its industry, specific events that occurred affecting the issuer and our ability and intent to retain the investment for a period of time sufficient to allow for a recovery in value. If our policy for determining the recognition of impaired positions were different, our Consolidated Statements of Financial Position and Statements of Operations could be significantly impacted. See also Item 8. “Financial Statements and Supplementary Data — Note 3 of Notes to Consolidated Financial Statements” contained within this report.
Ineffective business relationships, including outsourcing and partnering, could affect our ability to compete.
The inability to successfully build business relationships through partnering or outsourcing could have a material adverse effect on our business. As we purchase technologies or services from others, we are reliant upon our partners’ employee skill, performance and ability to fulfill fundamental business functions. This places our business performance at risk. The severity of such risk would be commensurate with the level of aptitude of the external vendors’ knowledge and/or technology. If the business partner does not act within the intended limits of their authority or does not perform in a manner consistent with our business objectives, this could lead to ineffective operational performance. The potential also exists for an agency or policyholder to experience dissatisfaction with a vendor which may have an adverse effect on our business and/or agency relationships.

9


 

Risk factors relating to the business of the Property and Casualty Group
The Property and Casualty Group faces significant competition from other regional and national insurance companies which may result in lower revenues. Additionally, we face the operational risk of potential loss resulting from inadequate or failed internal processes, people, and systems, or from external events.
The Property and Casualty Group competes with regional and national property/casualty insurers including direct writers of insurance coverage. Many of these competitors are larger and many have greater financial, technical and operating resources. In addition, there is competition within each insurance agency that represents other carriers as well as the Property and Casualty Group.
If we are unable to perform at industry leading levels with best practices in terms of quality, cost containment, and speed-to-market due to inferior operating resources and/or problems with external relationships, our business performance may suffer. As the business environment changes, if we are unable to adapt timely to emerging industry changes, or if our people do not conform to the changes, our business could be materially impacted.
The property/casualty insurance industry is highly competitive on the basis of product, price and service. If competitors offer property/casualty products with more coverage and/or better service or offer lower rates, and we are unable to implement product or service improvements quickly enough to keep pace, the Property and Casualty Group’s ability to grow and renew its business may be adversely impacted.
The internet continues growing as a method of distribution, both from existing competitors using their brand to write business and from new competitors. If the Property and Casualty Group’s method of distribution does not include advancements in technology that meet consumer preferences, its ability to grow and renew its business may be adversely impacted.
If the Erie Insurance Group is unable to keep pace with the rapidly developing technological advancements in the insurance industry or to replace its legacy policy administration systems, the ability of the Property and Casualty Group to compete effectively could be impaired.
Technological development is necessary to reduce our cost and the Property and Casualty Group’s operating costs and to facilitate agents’ and policyholders’ ability to do business with the Property and Casualty Group. If the Erie Insurance Group is unable to keep pace with the advancements being made in technology, its ability to compete with other insurance companies who have advanced technological capabilities will be negatively affected. Further, if the Erie Insurance Group is unable to update or replace its legacy policy administration systems as they become obsolete or as emerging technology renders them competitively inefficient, the Property and Casualty Group’s competitive position would be adversely affected.
Premium rates and reserves must be established for members of the Property and Casualty Group from forecasts of the ultimate costs expected to arise from risks underwritten during the policy period. Our underwriting profitability could be adversely affected to the extent such premium rates or reserves are too low.
One of the distinguishing features of the property and casualty insurance industry in general is that its products are priced before its costs are known, as premium rates are generally determined before losses are reported. Accordingly, premium rates must be established from forecasts of the ultimate costs expected to arise from risks underwritten during the policy period and may not prove to be adequate. Further, property and casualty insurers establish reserves for losses and loss adjustment expenses based upon estimates, and it is possible that the ultimate liability will exceed these estimates because of the future development of known losses, the existence of losses that have occurred but are currently unreported and larger than historical settlements on pending and unreported claims. The process of estimating reserves is inherently judgmental and can be influenced by factors that are subject to variation. If pricing or reserves established by a member of the Property and Casualty Group are not sufficient, our underwriting profitability may be adversely impacted.
The financial performance of members of the Property and Casualty Group could be adversely affected by severe weather conditions or other catastrophic losses, including terrorism.
The Property and Casualty Group conducts business in only 11 states and the District of Columbia, primarily in the mid-Atlantic, midwestern and southeastern portions of the United States. A substantial portion of this business is private passenger and commercial automobile, homeowners and workers’ compensation insurance in Ohio,

10


 

Maryland, Virginia and particularly, Pennsylvania. As a result, a single catastrophe occurrence, destructive weather pattern, general economic trend, terrorist attack, regulatory development or other condition disproportionately affecting one or more of the states in which the Property and Casualty Group conducts substantial business could adversely affect the results of operations of members of the Property and Casualty Group. Common natural catastrophe events include hurricanes, earthquakes, tornadoes, hail storms and severe winter weather. The frequency and severity of these catastrophes is inherently unpredictable. The extent of losses from a catastrophe is a function of both the total amount of insured exposures in the area affected by the event and the severity of the event.
Terrorist attacks could cause losses from insurance claims related to the property/casualty insurance operations, as well as a decrease in our shareholders’ equity, net income or revenue. The newly enacted federal Terrorism Risk Insurance Program Reauthorization and Extension Act of 2007 requires that some coverage for terrorist loss be offered by primary commercial property insurers and provides federal assistance for recovery of claims through 2014. While the Property and Casualty Group is exposed to terrorism losses in commercial lines and workers’ compensation, these lines are afforded a limited backstop above insurer deductibles for acts of terrorism under this federal program. The Property and Casualty Group has no personal lines terrorist coverage in place. The Property and Casualty Group could incur large net losses if future terrorist attacks occur.
The Property and Casualty Group maintains a property catastrophe reinsurance treaty that was renewed effective January 1, 2008 that provides coverage of 95% of a loss up to $400 million in excess of the Property and Casualty Group’s loss retention of $450 million per occurrence. This treaty excludes losses from acts of terrorism. Nevertheless, catastrophe reinsurance may prove inadequate if a major catastrophic loss exceeds the reinsurance limit which could adversely affect our underwriting profitability.
The Property and Casualty Group depends on independent insurance agents, which exposes the Property and Casualty Group to risks not applicable to companies with dedicated agents or other forms of distribution.
The Property and Casualty Group markets and sells its insurance products through independent, non-exclusive agencies. These agencies are not obligated to sell only the Property and Casualty Group’s insurance products, and generally they also sell competitors’ insurance products. As a result, the Property and Casualty Group’s business depends in large part on the marketing and sales efforts of these agencies. To the extent these agencies’ marketing efforts cannot be maintained at their current levels of volume or they bind the Property and Casualty Group to unacceptable insurance risks, fail to comply with established underwriting guidelines or otherwise improperly market the Property and Casualty Group’s products, the results of operations and business of the Property and Casualty Group could be adversely affected. Also, to the extent these agencies place business with competing insurers, due to compensation arrangements, product differences, price differences, ease of doing business or other reasons, the results of operations of the Property and Casualty Group could be adversely affected.
To the extent that business migrates to a delivery system other than independent agencies because of changing consumer preferences, the business of the Property and Casualty Group could be adversely affected. Also, to the extent the agencies choose to place significant portions or all of their business with competing insurance companies, the results of operations and business of the Property and Casualty Group could be adversely affected.
If there were a failure to maintain a commercially acceptable financial strength rating, the Property and Casualty Group’s competitive position in the insurance industry would be adversely affected.
Financial strength ratings are an important factor in establishing the competitive position of insurance companies and may be expected to have an effect on an insurance company’s sales. Higher ratings generally indicate greater financial stability and a stronger ability to meet ongoing obligations to policyholders. Ratings are assigned by rating agencies to insurers based upon factors that they believe are relevant to policyholders. Currently the Property and Casualty Group’s pooled AM Best rating is an A+ (“superior”). A significant future downgrade in this or other ratings would reduce the competitive position of the Property and Casualty Group making it more difficult to attract profitable business in the highly competitive property/casualty insurance market.
Changes in applicable insurance laws, regulations or changes in the way regulators administer those laws or regulations could adversely change the Property and Casualty Group’s operating environment and increase its exposure to loss or put it at a competitive disadvantage.
Property and casualty insurers are subject to extensive supervision in the states in which they do business. This regulatory oversight includes, by way of example, matters relating to licensing and examination, rate setting, market

11


 

conduct, policy forms, limitations on the nature and amount of certain investments, claims practices, mandated participation in involuntary markets and guaranty funds, reserve adequacy, insurer solvency, transactions between affiliates and restrictions on underwriting standards. Such regulation and supervision are primarily for the benefit and protection of policyholders and not for the benefit of shareholders. For instance, members of the Property and Casualty Group are subject to involuntary participation in specified markets in various states in which it operates, and the rate levels the Property and Casualty Group is permitted to charge do not always correspond with the underlying costs associated with the coverage issued. Although the federal government does not directly regulate the insurance industry, federal initiatives, such as federal terrorism backstop legislation, from time to time, also can impact the insurance industry.
Our ability to attract, develop and retain talented executives, key managers and employees is critical to our success.
Our future performance is substantially dependent upon our ability to attract, motivate and retain executives and other key management. The loss of the services and leadership of certain key officers and the failure to attract, motivate and develop talented new executives and managers could prevent us from successfully communicating, implementing and executing business strategies, and therefore have a material adverse effect on our financial condition and results of operations.
Our success also depends on our ability to attract, develop and retain a talented employee base. The inability to staff all functions of our business with employees possessing the appropriate technical expertise could have an adverse effect on our business performance. Staffing appropriately skilled employees for the deployment and maintenance of information technology systems and the appropriate handling of claims and rendering of disciplined underwriting, is critical to the success of our business.
Item 1B. Unresolved Staff Comments
None.
Item 2. Properties
The member companies of the Erie Insurance Group share a corporate home office complex in Erie, Pennsylvania, which is comprised of 500,000 square feet. The home office complex is owned by the Exchange. We are charged rent for the related square footage we occupy.
The Erie Insurance Group also operates 23 field offices in 11 states. Eighteen of these offices provide both agency support and claims services and are referred to as branch offices, while the remaining five provide only claims services and are considered claims offices. Three field offices are owned by the Exchange and leased to us. We incurred net rent expense for both the home office complex and the field offices leased from the Exchange totaling $5.8 million in 2007.
We own three field offices. One field office is owned by EFL and leased to us. The net rent expense for the field office leased from EFL was $0.3 million in 2007.
The remaining 16 field offices are leased from various unaffiliated parties. In addition to these field offices, we lease certain other facilities from unaffiliated parties. Net lease payments to external parties amounted to $2.9 million in 2007. Lease commitments for these properties expire periodically through 2012.
The total operating expense, including rent expense, for all office space we occupied in 2007 was $22.9 million. This amount was reduced by allocations to affiliates of $14.5 million. This net amount after allocations is reflected in our cost of management operations.
Item 3. Legal Proceedings
Reference is made to Item 8. “Financial Statements and Supplementary Data - Note 19 of Notes to Consolidated Financial Statements” contained within this report.

12


 

Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders during the fourth quarter of 2007.

13


 

PART II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Common stock market prices and dividends
Our Class A, non-voting common stock trades on The NASDAQ Stock MarketSM LLC under the symbol “ERIE.” No established trading market exists for the Class B voting common stock. American Stock Transfer & Trust Company serves as our transfer agent and registrar. As of February 15, 2008, there were approximately 937 beneficial shareholders of record of our Class A non-voting common stock and 18 beneficial shareholders of record of our Class B voting common stock.
The common stock high and low sales prices and dividends for each full quarter of the last two years were as follows:
                                                                   
      2007   2006
                      Cash Dividend                   Cash Dividend
      Sales Price   Declared   Sales Price   Declared
  Quarter ended   High   Low   Class A   Class B   High   Low   Class A   Class B
   
 
March 31
  $58.24     $51.75     $0.400     $60.00     $53.94     $51.13     $0.360     $54.00  
 
June 30
    56.62       52.01       0.400       60.00       52.90       49.67       0.360       54.00  
 
September 30
    62.29       50.70       0.400       60.00       53.03       48.49       0.360       54.00  
 
December 31
    61.41       50.52       0.440       66.00       58.25       49.55       0.400       60.00  
                                           
 
Total
                  $1.640     $246.00                     $1.480     $222.00  
                                           
We historically have 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, our earnings, financial condition and cash requirements at the time such payment is considered.
Stock performance
The following graph depicts the cumulative total shareholder return (assuming reinvestment of dividends) for the periods indicated for our Class A Common Stock compared to the Standard & Poor’s 500 Stock Index and the Standard & Poor’s Property and Casualty Insurance Index:
(PERFORMANCE GRAPH)
                                                   
      2002   2003   2004   2005   2006   2007
   
 
Erie Indemnity Company Class A common stock
  $100 *   $120     $151     $156     $175     $161  
 
Standard & Poor’s 500 Stock Index
    100 *     129       143       150       173       183  
 
Standard & Poor’s Property and Casualty Insurance Index
    100 *     126       140       161       181       157  
   
* Assumes $100 invested at the close of trading on the last trading day preceding the first day of the fifth preceding fiscal year in our Class A common stock, Standard & Poor’s 500 Stock Index and Standard & Poor’s Property and Casualty Insurance Index.  

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Issuer Purchases of Equity Securities
A stock repurchase plan was authorized allowing us to repurchase up to $250 million of our outstanding Class A common stock from January 1, 2004, through December 31, 2006. In February 2006, our Board of Directors reauthorized a $250 million stock repurchase program. In September 2007, our Board of Directors approved a continuation of the current stock repurchase program for an additional $100 million through December 31, 2008. We 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 our capital. Shares repurchased during 2007 totaled 2.6 million at a total cost of $137.7 million. Cumulative shares repurchased under this plan since inception was 9.6 million at a total cost of $508.0 million. See Item 8. “Financial Statements and Supplementary Data — Note 11 of Notes to Consolidated Financial Statements” contained within this report for discussion of additional shares repurchased outside of this plan from the F. William Hirt Estate in 2007.
                                   
                              Approximate
                              Dollar Value
                      Total Number of   of Shares that
      Total Number   Average   Shares Purchased   May Yet Be
      of Shares   Price Paid   as Part of Publicly   Purchased
  Period   Purchased   Per Share   Announced Plan   Under the Plan
 
October 1 — 31, 2007
    2,997     $56.90                
 
November 1 — 30, 2007
    122,923       54.31       122,923          
 
December 1 — 31, 2007
    198,035       51.56       198,035          
                           
 
Total
    323,955               320,958     $ 92,000,000  
                       
The month of October 2007 includes 2,997 shares that vested under the stock compensation plan for our outside directors. Included in this amount are the vesting of 2,724 shares of awards previously granted and 273 dividend equivalent shares that vest as they are granted (as dividends are declared by us).
In 2006 and 2007, we issued unregistered shares of our Class A nonvoting common stock in fulfillment of awards earned under compensation arrangements. Share awards paid out to executive officers under our Long-Term Incentive Plans were 23,690 on January 11, 2006, 21,388 on January 17, 2007, and 112,824 on May 24, 2007. Share awards paid to directors under the Deferred Compensation Plan for Outside Directors were 1,982 on May 12, 2006, 2,754 on May 7, 2007, and 3,416 on September 17, 2007.
The issuances of our securities described above were made in reliance upon the exemption from registration available under Section 4(2) of the Securities Act of 1933, as amended, as privately negotiated, isolated, non-recurring transactions not involving any public solicitation. The shares were issued to certain members of senior management who participate in our Long Term Incentive Plans, and to certain directors under our Deferred Compensation Plan for Outside Directors. The employee and director participants in each offering were sophisticated and had sufficient access to the kind of information registration would provide, including information contained in our filings under the Securities Exchange Act of 1934, as amended. Subsequent to the transactions noted above, on January 16, 2008, we filed a Registration Statement on Form S-8 with the SEC to register shares to be issued to officers and directors under certain equity compensation plans. Future issuances of shares under those plans will be made pursuant to such Registration Statement.

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Item 6. Selected Consolidated Financial Data
                                         
    ERIE INDEMNITY COMPANY
 
    Years Ended December 31,
 
                                       
(in thousands, except per share data)   2007   2006   2005   2004   2003
Operating data:
                                       
Total operating revenue
  $ 1,132,291     $ 1,133,982     $ 1,124,950     $ 1,123,144     $ 1,048,788  
Total operating expenses
    930,454       934,204       900,731       884,916       820,478  
Total investment income-unaffiliated
    107,331       99,021       115,237       88,119       66,743  
Provision for income taxes
    99,137       99,055       111,733       105,140       102,237  
Equity in earnings of Erie Family Life Insurance, net of tax
    2,914       4,281       3,381       5,206       6,909  
Net income
  $ 212,945     $ 204,025     $ 231,104     $ 226,413     $ 199,725  
 
                                       
Per share data:
                                       
Net income per share-diluted
  $ 3.43     $ 3.13     $ 3.34     $ 3.21     $ 2.81  
Book value per share-Class A common and equivalent B shares
    17.68       18.17   (1)   18.81       18.14       16.40  
Dividends declared per Class A share
    1.640       1.480       1.335       0.970       0.785  
Dividends declared per Class B share
    246.00       222.00       200.25       145.50       117.75  
 
                                       
Financial position data:
                                       
Investments(2)
  $ 1,277,781     $ 1,380,219     $ 1,452,431     $ 1,371,442     $ 1,241,236  
Receivables due from the Exchange and affiliates
    1,177,830       1,238,852       1,193,503       1,157,384       1,033,750  
Total assets
    2,878,623       3,039,361       3,101,261       2,982,804       2,756,329  
Shareholders’ equity
    1,051,279       1,161,848   (1)   1,278,602       1,266,881       1,164,170  
 
                                       
Cumulative number of shares repurchased at December 31,
    14,939   (3)   10,448       6,438       4,548       3,403  
(1) At December 31, 2006, shareholders’ equity decreased by $21.1 million, net of taxes, as a result of initially applying the recognition provisions of Statement of Financial Accounting Standards No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.”
(2) Includes investment in Erie Family Life Insurance.
(3) Includes 1.9 million shares of our Class A nonvoting common stock from the F. William Hirt Estate separate from our stock repurchase program.

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion of financial condition and results of operations highlight significant factors influencing our Company. This discussion should be read in conjunction with the audited financial statements and related notes and all other items contained within this Annual Report on Form 10-K, as they contain important information helpful in evaluating our operating results and financial condition.
Certain statements contained herein are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements are not in the present or past tense and can generally be identified by the use of words such as “anticipate,” “believe,” “estimate,” “expect,” “intend,” “likely,” “plan,” “project,” “seek,” “should,” “target,” “will,” and other expressions that indicate future trends and events. Forward-looking statements include, without limitation, statements and assumptions on which such statements are based that are related to our plans, strategies, objectives, expectations, intentions and adequacy of resources. Examples of such statements are discussions relating to management fee revenue, cost of management operations, underwriting, premium and investment income volumes, and agency appointments. Such statements are not guarantees of future performance and involve risks and uncertainties that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in such forward-looking statements. Among the risks and uncertainties that could cause actual results and future events to differ materially from those set forth or contemplated in the forward-looking statements are the following: factors affecting the property/casualty and life insurance industries generally, including price competition, legislative and regulatory developments, government regulation of the insurance industry including approval of rate increases, the size, frequency and severity of claims, natural disasters, exposure to environmental claims, fluctuations in interest rates, inflation and general business conditions; the geographic concentration of our business as a result of being a regional company; the accuracy of our pricing and loss reserving methodologies; changes in driving habits; our ability to maintain our business operations including our information technology system; our dependence on the independent agency system; the quality and liquidity of our investment portfolio; our dependence on our relationship with Erie Insurance Exchange; and the other risks and uncertainties discussed or indicated in all documents filed by the Company with the Securities and Exchange Commission, including those described in Part I, “Item 1A. Risk Factors” and elsewhere in this report. A forward-looking statement speaks only as of the date on which it is made and reflects the Company’s analysis only as of that date. The Company undertakes no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events, changes in assumptions, or otherwise.
OVERVIEW
The discussions below focus heavily on our three primary segments: management operations, insurance underwriting operations and investment operations. The segment basis financial results presented throughout Management’s Discussion and Analysis herein are those which management uses internally to monitor and evaluate results and are a supplemental presentation of our Consolidated Statements of Operations.
Economic and industrywide factors
Although we are primarily a management company, our earnings are driven largely by the management fee revenue we collect from the Exchange that is based on the direct written premiums of the Property and Casualty Group. The property/casualty insurance industry is highly cyclical, with periods of rising premium rates and shortages of underwriting capacity (“hard market”) followed by periods of substantial price competition and excess capacity (“soft market”). The insurance industry experienced continued price softening in 2007 where significant price competition resulted in a decline in premiums but produced strong underwriting results. AM Best’s estimated industry combined ratio of 95.6 in 2007 is a deterioration from the actual industry combined ratio of 92.4 in 2006. The lack of significant catastrophe losses and favorable loss reserve development in 2007 contributed to industry underwriting profitability and further boosted the robust capital levels of insurers. AM Best expects continued pressure on top-line growth in the industry in 2008 and is projecting a slight premium decline for the property/casualty industry. The Property and Casualty Group implemented significant rate reductions and other pricing actions in personal lines in 2007 resulting in a slight decline in direct written premiums for the Property and Casualty Group. We expect price stability in 2008 with only a minimal decrease of $8.8 million in direct written premium from rating actions taken. A period of declining premiums is especially challenging for us, as our revenues from management fees are dependent on growth in written premium, especially when the management fee rate is at its maximum rate of 25%, which was the case in 2007 and will be in 2008.
The credit environment turmoil caused by the subprime mortgage crisis has impacted the economy beginning in the second half of 2007. Insurers tend not to have significant investment exposure to subprime mortgage-backed securities partly due to restrictive state regulations. According to AM Best, insurers that may be subject to significant impact from the subprime crisis may be those who write coverages where liability may exist such as professional liability and errors and omissions policies as a result of class-action lawsuits related to subprime-related issues. We do not write directors and officers or errors and omissions coverages that would expose us to liability

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from subprime mortgage-backed credits. The majority of our fixed income portfolio is rated investment grade (BBB or higher). Approximately 5.0% of our fixed income portfolio is invested in structured mortgage-backed products that have an average rating of A+ or higher. We believe we have no direct exposure to the subprime residential mortgage market through investments in structured products. Similar to our portfolio, the Exchange’s fixed income portfolio is primarily rated investment grade. Approximately 9.9% of the Exchange’s fixed income portfolio is invested in structured products with an average rating of AA+.
In addition to the subprime credit crisis, we continue to monitor our municipal bond portfolio and the impact that credit rating downgrades of municipal bond insurers could have on our insured municipal bond portfolio. The municipal bond portfolio accounts for $249.4 million or 35.5% of the total fixed maturity portfolio. Our municipal portfolio is highly rated and includes all investment grade holdings (BBB or higher). The overall insured credit quality of the municipal bond portfolio is rated AAA. Insurance enhanced municipal bonds total $199.1 million, or 79.8% of the municipal bond portfolio. The overall credit quality of our municipal bond portfolio giving no effect to insurance is rated A+. Our investment policy has always been to invest in municipal bond holdings based on underlying issuer ratings and believe municipal bond insurer downgrades would not have a material adverse affect on the valuation of our fixed maturity holdings.
During 2007, we impaired $22.5 million of securities primarily in the banking and finance industries. Included in the total impairment charge were $5.1 million related to fixed maturities, $8.8 million related to preferred stock and $8.6 million in common stock. Similar to our increased level of impairments during 2007, the Exchange recognized impairment charges of $145.4 million with $41.7 million in bonds, $44.4 million in preferred stock and $59.3 million in common stock.
Revenue generation
We have three primary sources of revenue. First, approximately 72% of our revenues are generated by providing management services to the Exchange. The management fee is calculated as a percentage, not to exceed 25%, of the direct written premiums of the Property and Casualty Group. The Board of Directors establishes the rate at least annually and considers such factors as relative financial strength of the Exchange and Company and projected revenue streams. Our Board set the 2008 rate at 25%, its maximum level.
Second, we generate revenues from our property/casualty insurance subsidiaries, which consist of our share of the pooled underwriting results of the Property and Casualty Group. All members of the Property and Casualty Group pool their underwriting results. Under the pooling agreement, the Exchange assumes 94.5% of the Property and Casualty Group’s direct written premium. Through the pool, our subsidiaries, Erie Insurance Company and Erie Insurance Company of New York, currently assume 5.5% of the Property and Casualty Group’s direct written premium, providing a direct incentive for us to manage the insurance underwriting discipline as effectively as possible.
Finally, we generate revenues from our fixed maturity and equity investment portfolios, which provided nearly $50 million in pre-tax investment income during 2007. The portfolio is managed with a view toward maximizing after-tax yields and limiting credit risk. In addition, our portfolio of limited partnership investments generated nearly $60 million in earnings before tax.
Our results have allowed us to consistently generate high levels of cash flow from operations, which was $248.5 million in 2007. Our net cash flows from operations have been used to pay shareholder dividends and more recently to repurchase shares of our stock under our repurchase program.
Opportunities, challenges and risks
In order to grow our management fee revenue, our key challenges in 2008 continue to be profitable revenue growth in a time of heightened price competition. Containing the growth of expenses in our management operations is particularly important since it affects our gross margins from management operations and bears directly on Property and Casualty pricing, which is extremely competitive in soft markets. Expense management is further challenged by our need to enhance technology and improve ease of doing business for our Agents and policyholders.
In 2007, we increased penetration in our current territories through the appointment of 214 new agencies. During 2008, we plan to continue this momentum by appointing another 140 agencies. In 2007, we continued to develop the personal lines pricing plan, by introducing additional variables that further segment risks and allow us to be price competitive for the best risks. The Property and Casualty Group continues to evaluate potential new product offerings to meet consumer demands.
We plan to continue to control the growth in the cost of management operations by controlling salary and wage costs and other discretionary spending in 2008. However, we also intend to continue making targeted investments in technology to enhance customer service and ease of doing business with agents and customers, and improve productivity.

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Financial overview
                                           
      Years ended December 31,
              % Change           % Change    
              2007 over           2006 over    
  (in thousands, except per share data)   2007   2006   2006   2005   2005
 
 
Income from management operations
  $ 177,174       (5.0 )%   $ 186,408       (10.9 )%   $ 209,269  
 
Underwriting income
    24,663       84.5       13,370       (10.6 )     14,950  
 
Net revenue from investment operations
    110,464       6.6       103,625       (12.8 )     118,873  
   
 
Income before income taxes
    312,301       2.9       303,403       (11.6 )     343,092  
 
Provision for income taxes
    99,356       0.0       99,378       (11.3 )     111,988  
   
 
Net income
  $ 212,945       4.4     $ 204,025       (11.7 )   $ 231,104  
   
 
Net income per share-diluted
  $ 3.43       9.6 %   $ 3.13       (6.3 )%   $ 3.34  
   
Key points
  Increase in net income per share-diluted in 2007 impacted by improved underwriting operations and earnings from limited partnership investments.
 
  Gross margins from management operations decreased to 18.1% in 2007 from 19.2% in 2006.
 
  The management fee rate was 25% for 2007 and 24.75% for 2006.
 
  GAAP combined ratio of 88.1 in 2007 improved from 93.7 in 2006 due to severity trend improvements resulting in reserve redundancies.
 
    Net revenue from investment operations was positively impacted by a 42.9% increase in earnings from limited partnership investments in 2007. Equity in earnings of limited partnerships increased to $59.7 million in 2007 from $41.8 million in 2006.
Management operations
  Management fee revenue increased 0.4% and 0.3% in 2007 and 2006, respectively. The two determining factors of management fee revenue are: 1) the management fee rate we charge, and 2) the direct written premiums of the Property and Casualty Group. The management fee rate increased to 25% for 2007 from 24.75% for 2006, while the direct written premiums of the Property and Casualty Group were largely unchanged at $3.8 billion for 2007 and 2006.
 
  In 2007, the direct written premiums of the Property and Casualty Group decreased 0.5% compared to a 3.9% decline in 2006. New policy direct written premiums of the Property and Casualty Group increased 9.0% in 2007, compared to a 0.3% decrease in 2006. New business policies in force increased 6.4% in 2007, compared to 3.6% in 2006. Despite the growth in policies in force, rate reductions implemented in 2006 and 2007 resulted in the decline in the Property and Casualty Group’s direct written premiums.
 
    The cost of management operations increased 1.8%, or $13.9 million, to $799.6 million in 2007. The increase in cost of management operations in 2007 was the result of:
   -   Commissions—Total commission costs increased 0.6%, or $3.3 million, to $557.4 million in 2007. Normal scheduled rate commissions remained flat during 2007, while other agent incentives, including the first full-year impact of the $50 private passenger auto bonus, drove the increase in commissions.
 
   -  Total costs other than commissions—All other non-commission expense increased 4.6%, to $242.2 million in 2007, driven by personnel and other operating costs. Personnel costs increased primarily due to a $3.3 million charge related to the voluntary resignation of our former president and chief executive officer and higher average pay rates for our employees. Other operating costs increased due to a charge in the third quarter 2007 for a judgment against us of $4.3 million as well as increased expenses for additional software costs and professional fees related to various corporate projects.

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Insurance underwriting operations
Contributing to the positive insurance underwriting operating result of an 88.1 GAAP combined ratio were the following factors:
  lower pricing offset by improving severity trends resulted in a favorable 2007 accident year combined ratio;
 
  5.3 points, or $11.0 million, of favorable development on prior accident year loss reserves in 2007; and
 
    catastrophe losses totaling 1.7 points in 2007 that were below expected results.
Investment operations
  Net investment income decreased 5.5% in 2007 compared to 2006, as invested assets continued to decline in 2007 to fund stock repurchases of $236.7 million. Included in 2007 is a repurchase separately authorized by our Board of Directors for shares from the F. William Hirt Estate of $99.0 million.
 
  Net realized losses on investments totaled $5.2 million in 2007 compared to 2006 realized gains of $1.3 million primarily due to impairment charges of $22.5 million offset by gains on sales of common stock of $14.3 million.
 
    Equity in earnings of limited partnerships increased 42.9% in 2007 as a result of fair value appreciation from private equity partnerships and fair value appreciation and earnings from our real estate limited partnerships.
The topics addressed in this overview are discussed in more detail in the sections that follow.
CRITICAL ACCOUNTING ESTIMATES
In order to prepare financial statements in accordance with GAAP, we make estimates and assumptions that have a significant effect on reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period and related disclosures. Management considers an accounting estimate to be critical if (1) it requires assumptions to be made that were uncertain at the time the estimate was made, and (2) different estimates that could have been used, or changes in the estimate that are likely to occur from period to period, could have a material impact on our consolidated statements of operations or financial position.
The following presents a discussion of those accounting policies surrounding estimates that we believe are the most critical to our reported amounts and require the most subjective and complex judgment. If actual events differ significantly from the underlying assumptions and estimates used, there could be material adjustments to prior estimates that could potentially adversely affect our results of operations, financial condition and cash flows. The estimates and the estimating methods used are reviewed continually, and any adjustments considered necessary are reflected in current earnings.
Investment valuation
We make estimates concerning the valuation of all investments. We value fixed maturities and equity securities based on published market prices, except in rare cases where quoted market prices are not available.
Investments are evaluated monthly for other-than-temporary impairment loss. Some factors considered in evaluating whether or not a decline in fair value is other-than-temporary include:
  the extent and duration for which fair value is less than cost;
 
  historical operating performance and financial condition of the issuer;
 
  short- and long-term prospects of the issuer and its industry based on analysts’ recommendations;
 
  specific events that occurred affecting the issuer, including rating downgrades; and
 
    our ability and intent to retain the investment for a period of time sufficient to allow for a recovery in value.

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An investment deemed other than temporarily impaired is written down to its estimated fair value. Impairment charges are included as a realized loss in the Consolidated Statements of Operations.
The primary basis for the valuation of limited partnership interests are financial statements prepared by the general partner. Because of the timing of the preparation and delivery of these financial statements, the use of the most recently available financial statements provided by the general partners typically result in not less than a quarter delay in the inclusion of the limited partnership results in our Consolidated Statements of Operations. Nearly all of the underlying investments in our limited partnerships are valued using a source other than quoted prices in active markets. Our limited partnership holdings are considered investment companies where the general partners record assets at fair value. Several factors are to be considered in determining whether an entity is an investment company. Among these factors are a large number of investors, low level of individual ownership and passive ownership that indicate the entity is an investment company.
We have three types of limited partnership investments: private equity, mezzanine debt and real estate. Our private equity and mezzanine debt partnerships are diversified among various industries to minimize potential loss exposure. The fair value amounts for our private equity and mezzanine debt partnerships are based on the financial statements of the general partners, who use various methods to estimate fair value including the market approach, income approach and/or the cost approach. The market approach uses prices and other pertinent information from market-generated transactions involving identical or comparable assets or liabilities. Such valuation techniques often use market multiples derived from a set of comparables. The income approach uses valuation techniques to convert future cash flows or earnings to a single discounted present value amount. The measurement is based on the value indicated by current market expectations about those future amounts. The cost approach is derived from the amount that is currently required to replace the service capacity of an asset. If information becomes available that would impair the cost of these partnerships, then the general partner would generally adjust to the net realizable value.
Real estate limited partnerships are recorded at fair value based on independent appraisals and/or internal valuations. Real estate projects under development are generally valued at cost and impairment tested by the general partner. We minimize the risk of market decline by avoiding concentration in a particular geographic area and are diversified across residential, commercial, industrial and retail real estate investments.
We perform various procedures in review of the general partners’ valuations, and while we rely on the general partners’ financial statements as the best available information to record our share of the partnership unrealized gains and losses resulting from valuation changes, we adjust our financial statements where appropriate. As there is no ready market for these investments, they have the greatest potential for variability. We survey each of the general partners about expected significant changes (plus or minus 10% compared to previous quarter) to valuations prior to the release of the fund’s quarterly and annual financial statements. In the event of an expected significant change, the general partner will notify us and we will consider whether or not disclosure is warranted.
Property/casualty insurance liabilities
Reserves for property/casualty insurance unpaid losses and loss adjustment expenses reflect our best estimate of future amounts needed to pay losses and related expenses with respect to insured events. These reserves include estimates for both claims that have been reported and those that have been incurred but not reported. They also include estimates of all future payments associated with processing and settling these claims. Reported losses represent cumulative loss and loss adjustment expenses paid plus case reserves for outstanding reported claims. Case reserves are established by a claims handler on each individual claim and are adjusted as new information becomes known during the course of handling the claims. Incurred but not reported reserves represent the difference between the actual reported loss and loss adjustment expenses and the estimated ultimate cost of all claims.
The process of estimating the liability for property/casualty unpaid loss and loss adjustment expense reserves is complex and involves a variety of actuarial techniques. This estimation process is based largely on the assumption that past development trends are an appropriate indicator of future events. Reserve estimates are based on our assessment of known facts and circumstances, review of historical settlement patterns, estimates of trends in claims frequency and severity, legal theories of liability and other factors. Variables in the reserve estimation process can be affected by 1) internal factors, including changes in claims handling procedures and changes in the quality of risk selection in the

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underwriting process, and 2) external events, such as economic inflation, regulatory and legislative changes. Due to the inherent complexity of the assumptions used, final loss settlements may vary significantly from the current estimates, particularly when those settlements may not occur until well into the future.
Our actuaries review reserve estimates for both current and prior accident years using the most current claim data, on a quarterly basis, for all direct reserves except the reserves for the pre-1986 automobile catastrophic injury liability that are reviewed semi-annually. These catastrophic injury reserves are reviewed semi-annually because of the relatively low number of cases and the long-term nature of these claims. For reserves that are reviewed semi-annually, our actuaries monitor the emergence of paid and reported losses in the intervening quarters to either confirm that the estimate of ultimate losses should not change, or if necessary, perform a reserve review to determine whether the reserve estimate should change. Significant changes to the factors discussed above, which are either known or reasonably projected through analysis of internal and external data, are quantified in the reserve estimates each quarter.
The quarterly reserve reviews incorporate a variety of actuarial methods and judgments and involve rigorous analysis. The various methods generate different estimates of ultimate losses by product line and product coverage combination. Thus, there are no reserve ranges, but rather point estimates of the ultimate losses developed from the various methods. The methods that are considered more credible vary by product coverage combination based primarily on the maturity of the accident quarter, the mix of business and the particular internal and external influences impacting the claims experience or the method.
Paid loss development patterns, generated from historical data, are generally less useful for the more recent accident quarters of long-tailed lines since a low percentage of ultimate losses are paid in early periods of development. Reported loss (including cumulative paid losses and case reserves) development patterns, generated from historical data, estimate only the unreported losses rather than the total unpaid losses as this technique is affected by changes in case reserving practices. Combinations of the paid and reported methods are used in developing estimated ultimate losses for short-tail coverages, such as private passenger auto property and homeowners claims, and more mature accident quarters of long-tail coverages, such as private passenger auto liability claims and commercial liability claims, including workers compensation. The Bornhuetter-Ferguson method combines a reported development technique with an expected loss ratio technique. An expected loss ratio is developed through a review of historical loss ratios by accident quarter, as well as expected changes to earned premium, mix of business and other factors that are expected to impact the loss ratio for the accident quarter being evaluated. This method is generally used on the first four to eight accident quarters on long-tail coverages because a low percentage of losses are paid in the early period of development.
The reserve review process involves a comprehensive review by our actuaries of the various estimation methods and reserve levels produced by each. These multiple reserve point estimates are reviewed by our reserving actuaries and reserve best estimates are selected. The selected reserve estimates are discussed with management. Numerous factors are considered in setting reserve levels, including, but not limited to, the assessed reliability of key loss trends and assumptions that may be significantly influencing the current actuarial indications, the maturity of the accident year, pertinent claims frequency and severity trends observed over recent years, the level of volatility within a particular line of business and the improvement or deterioration of actuarial indications in the current period as compared to prior periods.
We also perform analyses to evaluate the adequacy of past reserve levels. Using subsequent information, we perform retrospective reserve analyses to test whether previously established estimates for reserves were reasonable. Our 2007 retrospective analysis indicated the Property and Casualty Group’s December 31, 2006 direct reserves had an estimated redundancy of approximately $270 million, which was about 7.5% of total reserves.
The Property and Casualty Group’s coverage with the greatest potential for variation are the catastrophic injury liability reserves. Workers compensation policies and the automobile no-fault law in Pennsylvania before 1986 provide for unlimited medical benefits. The estimate of ultimate liabilities for these claims is subject to significant judgment due to variations in claimant health, mortality over time and health care cost trends. Because the coverage related to these claims is unique and the number of claims is less than 150, the previously discussed methods are not used; rather ultimate losses are estimated on a claim-by-claim basis. An annual payment assumption is made for each of these claimants who sustained catastrophic injuries and then projected into the future based upon a particular assumption of the future inflation rate, including medical inflation and life expectancy of the claimant. At December 31, 2007, the reserve carried by the Property and Casualty Group for the pre-1986 automobile catastrophic injury liabilities, which is our best estimate of this liability at this time, was $299.0 million, which is net of $163.2 million of anticipated reinsurance

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recoverables. Our property/casualty subsidiaries’ share of the net automobile catastrophic injury liability reserve is $16.4 million at December 31, 2007. The most significant variable in estimating this liability is medical cost inflation. Our medical inflation rate assumption in setting this reserve for 2007 is for a 10% annual increase grading down 1% per year to an ultimate rate of 5%. Each 100-basis point change in the medical cost inflation assumption would result in a change in net liability for us of $2.9 million. In 2007, we changed our mortality rate assumption to give 75% weight to our own mortality experience and 25% weight to a disabled pensioner mortality table. Prior to this, we used a mortality assumption based 100% on our actual mortality experience only. Our actual mortality experience for disabled lives of catastrophically injured people is based on a relatively small number of lives. We believe weighting the mortality assumption to incorporate the disabled pensioner mortality table, which has longer mortality than our experience, is reasonable in estimating our ultimate liability for these claims.
In 2007, the workers compensation catastrophic injury claims were segregated from the total population of workers compensation claims and ultimate losses were developed on a claim-by-claim basis. Similar to the pre-1986 automobile catastrophic injury liability, these reserves are subject to significant judgment due to variations in claimant health, mortality over time and health care cost trends. At December 31, 2007, the reserve carried by the Property and Casualty Group for these workers compensation catastrophic injury reserves, which is our best estimate of this liability at this time, was $241.5 million, which is net of $13.1 million of anticipated reinsurance recoverables. Our property/casualty insurance subsidiaries’ share of the workers compensation catastrophic injury reserves is $13.3 million at December 31, 2007.
Retirement benefit plans
Our pension plan for employees is the largest and only funded benefit plan we offer. Our pension and other retirement benefit obligations are developed from actuarial estimates in accordance with Financial Accounting Standard (FAS) 87, “Employers’ Accounting for Pensions.” Several statistical and other factors, which attempt to anticipate future events, are used in calculating the expense and liability related to the plans. Key factors include assumptions about the discount rates and expected rates of return on plan assets. We review these assumptions annually and modify them considering historical experience, current market conditions, including changes in investment returns and interest rates, and expected future trends.
Accumulated and projected benefit obligations are expressed as the present value of future cash payments. We discount those cash payments using the prevailing market rate of a portfolio of high-quality fixed-income debt instruments with maturities that correspond to the payment of benefits. Lower discount rates increase present values and subsequent year pension expense; higher discount rates decrease present values and subsequent year pension expense. In determining the discount rate, we performed a bond-matching study. The study developed a portfolio of non-callable bonds rated AA- or better. For some years, there were no bonds maturing. In these instances, the study estimated the appropriate bond by assuming that there would be bonds available with the same characteristics as the available bond maturing in the immediately following year. The cash flows from the bonds were matched against our projected benefit payments in the pension plan, which have a duration of about 18 years. This bond-matching study supported the selection of a 6.62% discount rate for the 2008 pension expense. The 2007 expense was based on a discount rate assumption of 6.25%. A change of 25 basis points in the discount rate assumption, with other assumptions held constant, would have an estimated $1.7 million impact on net pension and other retirement benefit costs in 2008, before consideration of expense allocation to affiliates.
Unrecognized actuarial gains and losses are being recognized over a 15-year period, which represents the expected remaining service life of the employee group. Unrecognized actuarial gains and losses arise from several factors, including experience and assumption changes in the obligations and from the difference between expected returns and actual returns on plan assets. These unrecognized losses are recorded in the pension plan obligation on the Statements of Financial Position and Accumulated Other Comprehensive Income in 2007 in accordance with FAS 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.” These amounts are systematically recognized as an increase to future net periodic pension expense in accordance with FAS 87 in future periods.
The expected long-term rate of return for the pension plan represents the average rate of return to be earned on plan assets over the period the benefits included in the benefit obligation are to be paid. The expected long-term rate of return is less susceptible to annual revisions, as there are typically not significant changes in the asset mix. The long-

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term rate of return is based on historical long-term returns for asset classes included in the pension plan’s target allocation. A reasonably possible change of 25 basis points in the expected long-term rate of return assumption, with other assumptions held constant, would have an estimated $0.7 million impact on net pension benefit cost before consideration of reimbursement from affiliates.
The actuarial assumptions used by us in determining our pension and retirement benefits may differ materially from actual results due to changing market and economic conditions, higher or lower withdrawal rates or longer or shorter life spans of participants. While we believe that the assumptions used are appropriate, differences in actual experience or changes in assumptions may materially affect our financial position or results of operations. Further information on our retirement benefit plans is provided in Item 8 “Financial Statements and Supplementary Data - Note 8 of the Notes to Consolidated Financial Statements” contained within this report.
NEW ACCOUNTING STANDARDS
See “Financial Statements and Supplementary Data - Note 2 of the Notes to Consolidated Financial Statements” contained within this report for a discussion of recently issued accounting pronouncements.
RESULTS OF OPERATIONS
Management operations
                                           
      Years ended December 31,
              % Change           % Change    
              2007 over           2006 over    
  (in thousands)   2007   2006   2006   2005   2005
 
 
Management fee revenue
  $ 947,023       0.4 %   $ 942,845       0.3 %   $ 940,274  
 
Service agreement revenue
    29,748       1.7       29,246       42.2       20,568  
   
 
Total revenue from management operations
    976,771       0.5       972,091       1.2       960,842  
 
Cost of management operations
    799,597       1.8       785,683       4.5       751,573  
   
 
Income from management operations
  $ 177,174       (5.0 )%   $ 186,408       (10.9 )%   $ 209,269  
   
 
Gross margin
    18.1  %             19.2  %             21.8  %
 
Key points
  The management fee rate was 25% in 2007 compared to 24.75% in 2006.
 
    Direct written premiums of the Property and Casualty Group decreased 0.5% in 2007.
  - Policies in force increased 2.4% to 3,888,333 in 2007 from 3,798,297 in 2006.
 
  - Year-over-year average premium per policy was $973 in 2007 and $1,001 in 2006, a decrease of 2.8%.
 
  -   Premium rate changes resulted in an $86 million decrease in 2007 written premiums.
  Costs other than commissions increased 4.6% while commission costs increased 0.6% in 2007.
  - A $50 private passenger auto incentive increased $3.1 million due to the full-year impact of the bonus in 2007 which was introduced in July 2006. Accelerated rate commissions increased $1.3 million as a result of the continued expansion of our independent agency force.
 
  -   Personnel costs increased 1.7%, or $2.4 million, primarily due to:
    a $3.3 million charge related to the resignation of our president and chief executive officer previously discussed,
 
    higher average pay rates offset by lower staffing levels, and
 
    a $2.3 million reduction in the expense for management incentive plans resulting from fluctuations in the

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      market value of estimated shares and lower than targeted performance under the plan.
  -   All other operating costs increased 21.1%, or $9.9 million due to professional fees increasing $4.0 million which were mostly information technology related, and the recording of a $4.3 million charge for a judgment against us.
Management fee revenue
The following table presents the direct written premium of the Property and Casualty Group, shown by major line of business, and the calculation of the management fee revenue of the Company.
                                           
              Years ended December 31,    
              % Change           % Change    
              2007 over           2006 over    
  (in thousands)   2007   2006   2006   2005   2005
 
 
Private passenger auto
  $ 1,802,603       (0.5 )%   $ 1,812,177       (5.8 )%   $ 1,923,992  
 
Homeowners
    732,883       1.1       725,161       (1.5 )     735,873  
 
Commercial multi-peril
    435,630       (1.1 )     440,564       (1.0 )     445,165  
 
Workers compensation
    306,563       (5.0 )     322,737       (7.6 )     349,240  
 
Commercial auto
    315,851       (1.9 )     321,992       (2.5 )     330,172  
 
All other lines of business
    191,361       5.9       180,783       4.8       172,500  
   
 
Property and Casualty Group direct written premiums
  $ 3,784,891       (0.5 )%   $ 3,803,414       (3.9 )%   $ 3,956,942  
 
Effective management fee rate
    25.00%             24.75 %               23.75 %  
   
 
Management fee revenue, gross
  $ 946,223       0.5 %   $ 941,345       0.2  %   $ 939,774  
 
Change in allowance for management fee returned on cancelled policies(1)
    800     NM       1,500     NM       500  
   
 
Management fee revenue, net of allowance
  $ 947,023       0.4 %   $ 942,845       0.3 %   $ 940,274  
   
NM = not meaningful
(1)   Management fees are returned to the Exchange when policies are cancelled mid-term and unearned premiums are refunded. We record an estimated allowance for management fees returned on mid-term policy cancellations.
Management fee rate
Management fee revenue is based upon the management fee rate, determined by our Board of Directors, and the direct written premiums of the Property and Casualty Group. Changes in the management fee rate can affect our revenue and net income significantly. The higher management fee rate of 25% in 2007 resulted in an increase of $9.5 million in management fee revenue, or $0.10 per share-diluted. The management fee rate was once again set at the maximum rate of 25% for 2008 by our Board of Directors.
Estimated allowance
Management fees are returned to the Exchange when policyholders cancel their insurance coverage mid-term and unearned premiums are refunded to them. We maintain an allowance for management fees returned on mid-term policy cancellations that recognizes the management fee anticipated to be returned to the Exchange based on historical mid-term cancellation experience. Mid-term policy cancellations continued to decline in 2007 evidenced by the improvement in the retention ratio to 90.2% at December 31, 2007, compared to 89.5% at December 31, 2006, and 88.6% at December 31, 2005. As a result, management fee revenues increased in each of these three years due to reductions in this allowance. Our cash flows are unaffected by the recording of this allowance.
Direct written premiums of the Property and Casualty Group
Direct written premiums of the Property and Casualty Group were positively impacted by an increase in policies in force of 2.4%, offset by rate reductions taken in 2007 and 2006. Total policies in force increased to 3,888,333 in 2007, from 3,798,297 in 2006. The year-over-year average premium per policy for all lines of business decreased 2.8% to $973 in 2007, from $1,001 in 2006.
Policies in force have grown since stabilizing in 2005 when our segmented pricing model was first implemented for personal lines. Total policies in force grew 1.0% in 2006 compared to 2005. New business policies in force grew 6.4% in 2007 and 3.6% in 2006. The Property and Casualty Group’s premiums generated from new business increased 9.0%, to

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$401.0 million in 2007 from $368.0 million in 2006, which was 0.3% lower than the $369.1 million produced in 2005. The year-over-year average premium per policy on new business increased 2.5% to $862 in 2007 from $841 in 2006, which was 3.8% lower than the average $874 in 2005.
Premiums generated from renewal business decreased 1.5% to $3.4 billion in 2007 compared to 2006, which was lower than the $3.6 billion in 2005. Renewal policies in force increased 1.9% to 3,422,936 in 2007 from 3,360,672 in 2006, while the year-over-year average premium per policy on renewal business decreased 3.3% to $989 in 2007 from $1,022 in 2006. Our policy retention ratios have been steadily improving to a 12-month moving average of 90.2% in 2007, up from 89.5% in 2006 and 88.6% in 2005.
Due to continued soft market conditions, the Property and Casualty Group implemented rate reductions in 2005, 2006 and 2007 to be more price-competitive for potential new policyholders and to improve retention of existing policyholders. The Property and Casualty Group writes only one-year policies. Consequently, rate actions take 12 months to be fully recognized in written premium and 24 months to be recognized fully in earned premiums. Since rate changes are realized at renewal, it takes 12 months to implement a rate change to all policyholders and another 12 months to earn the decreased or increased premiums in full. As a result, certain rate actions approved in 2006 were reflected in written premium in 2007, and some rate actions in 2007 will be reflected in 2008. The effect on 2007 premiums written of all rate actions resulted in a net decrease in written premiums of $85.9 million. The Property and Casualty Group’s most significant rate reductions in 2007 were in private passenger auto in Pennsylvania and Ohio and homeowners in Pennsylvania, Maryland and Virginia.
The Property and Casualty Group’s 3.9 % decrease in direct written premiums in 2006, compared to 2005, resulted from more significant rate reductions in lines of business under competitive pressure, such as private passenger auto. The effect on 2006 premiums written from rate actions resulted in a net decrease in written premiums of $119.5 million. The effect on 2005 premiums written from rate action was a net decrease of $9.9 million in written premium. We continuously evaluate pricing actions and estimate that those approved, filed and contemplated for filing during 2008 could result in a net reduction to direct written premiums of $8.8 million in 2008.
Personal lines
Personal lines new business premiums written increased 5.4% to $260.4 million in 2007 from $247.1 million in 2006 and $246.2 million in 2005. The year-over-year average premium per policy on personal lines new business increased 0.4% to $687 in 2007 from $684 in 2006, which was 3.5% lower than the 2005 average of $709. Personal lines new business policies in force rose 4.9% to 378,994 in 2007, from 361,147 in 2006, which was 4.1% higher than 347,087 in 2005. Total personal lines policies in force increased 2.2% in 2007 to 3,386,377.
The Property and Casualty Group’s new business private passenger auto premiums increased 7.6% to $161.7 million in 2007 from $150.3 million in 2006. Private passenger auto new business policies in force increased 7.3% to 157,297 in 2007 compared to 146,594 in 2006. A new incentive program that was implemented in July 2006 to stimulate policy growth has contributed to the increase in new business policies in force. Under the program, agents receive a $50 bonus on each qualifying new private passenger auto policy. This incentive program runs through June 30, 2008. Certain pricing actions that became effective in 2007 increased rates, primarily in Maryland and Virginia, and reduced rates in Pennsylvania and Ohio. In 2006, the private passenger auto new premiums remained consistent at $150.3 million compared to $149.1 million in 2005 despite a 6.9% increase in new policies in force. The Property and Casualty Group’s rate reductions taken in 2005 and 2006 had the most significant dollar impact in private passenger auto in Pennsylvania, causing the year-over-year average premium per policy to decrease 5.8% in 2006.
Renewal premiums written decreased 0.3% on total personal lines policies during 2007 and decreased 4.3% in 2006. Improving policy retention trends were offset by the impact of rate reductions and change in the mix of personal lines business written by the Property and Casualty Group. The renewal business year-over-year policy retention ratio for personal lines improved to 90.8% in 2007 from 90.1% in 2006 and 89.1% in 2005. The year-over-year policy retention ratio for private passenger auto was 91.5% in 2007, 90.8% in 2006 and 90.0% in 2005.
Industry private passenger auto premiums for 2008 are expected to experience a modest decline as a result of competitive pricing and a weakening economy. For the industry, the homeowners rate of premium growth has slowed, and may slow further in 2008, especially in light of the slowing housing market.

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Commercial lines
Driving the premium decreases in our major commercial lines in 2007 compared to 2006 are lower renewal premiums, which decreased 4.3% to $995.5 million in 2007, reflecting the impact of rate reductions being implemented over the past three years. Also in 2007, we discontinued dividends on certain workers compensation policies and instead implemented a tiered pricing structure to better align rates and associated risks. Despite the decreases in renewal premiums, commercial lines new business premiums written increased 16.3% to $140.1 million in 2007, from $120.4 million in 2006, which had decreased 1.5% from $122.3 million in 2005. The year-over-year average premium per policy on commercial lines new business increased 3.0% to $1,621 in 2007, from $1,575 in 2006 which was 3.2% lower than the average of $1,626 in 2005. Commercial lines new business policies in force increased to 86,403 at December 31, 2007, up 13.0% from 76,478 at December 31, 2006, which was up 1.7% from 75,197 at December 31, 2005.
Factors contributing to the increase in new commercial lines premiums written in 2007 include more proactive communications between us and our commercial agents, continued refinement and enhancements to our quote processing systems and our use of more refined pricing based on predictive modeling. The increase in the average premium per policy on commercial lines new business in 2007 resulted from certain workers’ compensation pricing actions that increased rates in Illinois, Maryland and Virginia, that first became effective in 2006. In 2006, the average written premium per policy had declined on commercial lines new business, reflecting rate decreases and changes in the size and risk characteristics to smaller and more preferred risks.
Renewal premiums written for commercial lines policies decreased 4.3% during 2007 and 3.2% during 2006. The overall decrease is reflective of the impact of rate reductions and changes in the mix of business. The year-over-year average policy retention ratio for commercial lines was 85.7%, 85.4% and 85.2% in 2007, 2006 and 2005, respectively.
Industry commercial rate levels weakened in 2005, 2006 and 2007 with price pressures expected to continue in 2008. The Property and Casualty Group’s most significant rate reductions, effective in 2006 that are continuing to be earned in 2007, are in workers compensation in the state of Pennsylvania and commercial auto in the state of Virginia. Rate actions approved for 2008 are primarily for commercial multi-peril in the states of Pennsylvania and Ohio and workers compensation in Virginia and Maryland.
Future trends—premium revenue
We are continuing our efforts to grow Property and Casualty Group premiums and improve our competitive position in the marketplace. Expanding the size of the agency force will contribute to future growth as new agents build up their book of business with the Property and Casualty Group. We expect our trend of increasing agency appointments to continue with a goal of appointing 140 new agencies in 2008. In 2007, we appointed 214 new agencies and had a total of 1,964 agencies as of December 31, 2007. We continue to evaluate the interactions used in our pricing model, as well as other product extensions and enhancements that could be introduced. In September 2007 we announced plans to continue our geographic expansion effort into the state of Minnesota with the intent of writing business in the state sometime in 2009. West Virginia’s workers compensation system is transitioning to an open-market system that will take effect in July 2008. The Property and Casualty Group is preparing to begin writing workers compensation business in West Virginia in 2008 once that occurs.
Service agreement revenue
Service agreement revenue includes service charges we collect from policyholders for providing extended payment terms on policies written by the Property and Casualty Group. The service charges are fixed dollar amounts per billed installment. Gross service agreement revenue amounted to $29.6 million in 2007, $30.2 million in 2006 and $20.8 million in 2005. The decrease in service agreement revenue in 2007 was impacted by a shift to the no-fee, single payment plan driven by a discount in pricing offered for paid-in-full policies as well as consumers desire to not incur service charges. The 2006 service agreement revenue increased from 2005 due to an increase in the service charge assessed to policyholders from $3 to $5 per installment, effective for policies renewing on or after January 1, 2006, that are paid in installments. Shifts in the billing plans to those in which a fee is not assessed offset some of the increase in the installment charge.
During 2007, we filed for approval with each of our 11 states and District of Columbia to implement late payment and policy reinstatement fees on policyholder accounts that are past due or lapsed in coverage due to non-payment of premiums. As of December 31, 2007, all states except North Carolina have approved the fees with other states placing

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exceptions on certain lines of business. We expect to introduce these new fees where permitted in March 2008. Service agreement revenue is expected to increase $4.5 million in 2008 as a result of these new fees. This estimate is based on current policyholder late payment patterns that may be influenced by these fees and thus, could reduce this estimate once fully implemented.
Cost of management operations
                                           
      Years ended December 31,
              % Change           % Change    
              2007 over           2006 over    
  (in thousands)   2007   2006   2006   2005   2005
 
 
Commissions
  $ 557,359       0.6  %   $ 554,041       2.7  %   $ 539,438  
 
 
Personnel costs
    138,948       1.7       136,560       9.5       124,689  
 
Survey and underwriting costs
    23,710       (5.3 )     25,040       14.0       21,964  
 
Sales and policy issuance costs
    22,556       (1.7 )     22,945       3.8       22,096  
 
All other operating costs
    57,024       21.1       47,097       8.6       43,386  
   
 
All other non-commission expense
    242,238       4.6       231,642       9.2       212,135  
   
 
Total cost of management operations
  $ 799,597       1.8  %   $ 785,683       4.5  %   $ 751,573  
   
Key points
    In 2007, scheduled rate commissions remained level while other agent incentives drove the $3.3 million increase in total commissions.
 
    The increase in personnel costs resulted from:
  - a $3.3 million increase related to the voluntary resignation of our former chief executive officer, as previously discussed,
 
  - higher average pay rates offset by lower staffing levels, and
 
  -   a $2.3 million decrease in the expense for management incentive plans in 2007 as a result of fluctuations in the market value of the estimated shares and lower than targeted performance.
     All other operating costs increased $9.9 million due to a charge for the judgment against us of $4.3 million and an increase in professional fees related to various initiatives of $4.0 million.
Commissions
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, accelerated commissions and agent bonuses and are outlined in the following table:
                                           
      Years ended December 31,
              % Change           % Change    
              2007 over           2006 over    
  (in thousands)   2007   2006   2006   2005   2005
 
 
Scheduled rate commissions
  $ 451,587       0.0  %   $ 451,531       (2.6 )%   $ 463,473  
 
Accelerated rate commissions
    2,880       80.2       1,598       (35.8 )     2,490  
 
Agent bonuses
    95,854       1.2       94,754       33.3       71,083  
 
Promotional incentives
    813       (66.6 )     2,434       35.8       1,792  
 
$50 private passenger auto bonus
    5,825     NM     2,724     NM      
 
Change in commissions allowance for mid-term policy cancellations
    400     NM     1,000     NM     600  
   
 
Total commissions
  $ 557,359       0.6  %   $ 554,041       2.7  %   $ 539,438  
   
NM = not meaningful

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Scheduled and accelerated rate commissions
Scheduled rate commissions were impacted by a 0.5% decrease in the direct written premiums of the Property and Casualty Group in 2007. Scheduled rate commissions remained flat in 2007 due to the decrease in direct written premiums offset by an increase in certain workers compensation commission rates which became effective August 1, 2007 in certain states, and added $1.2 million of commission expense in 2007. The decrease of scheduled rate commissions in 2006 of 2.6% from 2005 was driven by the reduction in the direct written premiums of the Property and Casualty Group of 3.9% in 2006.
Accelerated rate commissions are offered under specific circumstances to certain newly-recruited agencies for their initial three years of operation. Accelerated rate commissions are increasing as expected given the additional new agency appointments in recent years. We appointed 214 new agencies in 2007, 139 in 2006 and 65 in 2005. There were 216 agencies receiving accelerated rate commissions in 2007 compared to 118 and 98 in 2006 and 2005, respectively. Accelerated commissions are expected to continue to increase in the future as a result of these recent new agency appointments and those expected in 2008.
Agent bonuses and promotional incentives
Agent bonuses are based predominantly on an individual agency’s property/casualty underwriting profitability over a three-year period. There is also a growth component to the bonus, paid only if the agency is profitable. The estimate for the bonus is modeled on a monthly basis using the two prior years’ actual underwriting data by agency combined with the current year-to-date actual data. Given the strong underwriting profitability of the most recent three years, 2007 agent bonuses increased 1.2% over 2006. The 33.3% increase in 2006 compared to 2005 included two of these years with our strongest underwriting profitability. The agent bonus award was estimated at $94.1 million for 2007. Of this estimate, $90.4 million represents the profitability component and $3.7 million represents the growth component of the award.
$50 private passenger auto bonus
In July 2006, an incentive program was implemented that was originally planned to run through December 31, 2007. In October 2007, management approved an extension of this incentive program through June 30, 2008. The program pays a $50 bonus to agents for each qualifying new private passenger auto policy issued. The cost of this program was $5.8 million in 2007 and $2.7 million in 2006. These incentive program costs are estimated to be $3.3 million for 2008.
Other costs of management operations
Personnel costs, the second largest component in the cost of management operations, increased 1.7% in 2007. Contributing to the increase in personnel costs was $3.3 million in compensation recognized for the voluntary resignation of our former chief executive officer. Higher average pay rates also contributed to this increase, after being offset by the impact of lower staffing levels. Offsetting these increases was a $2.3 million decrease in expense for the management incentive plans attributable to fluctuations in the market value of the estimated shares and lower than targeted performance under the plans.
All other operating costs increased 21.1% in 2007. The primary drivers of this increase include 1) a $4.3 million accrual for a judgment against us, 2) $4.0 million in increased professional fees related to various corporate initiatives, and 3) $2.6 million in additional software purchases, software maintenance and license agreements.
Future trends—cost of management operations
The competitive position of the Property and Casualty Group is based on many factors including price considerations, service levels, ease of doing business, product features and billing arrangements, among others. Pricing of Property and Casualty Group policies is directly affected by the cost structure of the Property and Casualty Group and the underlying costs of sales, underwriting activities and policy issuance activities performed by us for the Property and Casualty Group. In 2006, management worked to better align our growth in costs to our growth in premium over the long-term. Our goal for 2007 was to hold growth in non-commission costs to 6% or less. Actual growth in non-commission costs for 2007 was 4.6%.

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Insurance underwriting operations
                                           
      Years ended December 31,
              % Change           % Change    
              2007 over           2006 over    
  (in thousands)   2007   2006   2006   2005   2005
   
 
Premiums earned
  $ 207,562       (2.9 )%   $ 213,665       (1.0 )%   $ 215,824  
   
 
Losses and loss adjustment expenses incurred
    125,903       (9.8 )     139,630       (0.5 )     140,385  
 
Policy acquisition and other underwriting expenses
    56,996       (6.0 )     60,665       0.3       60,489  
   
 
Total losses and expenses
    182,899       (8.7 )     200,295       (0.3 )     200,874  
   
 
Underwriting income
  $ 24,663       84.5  %   $ 13,370       (10.6 )%   $ 14,950  
   
Key points
    Earned premiums declined $6.1 million in 2007, reflecting the impact of rate reductions taken in 2006 and 2007.
 
    Favorable development of prior accident year losses, excluding salvage and subrogation recoveries, improved the GAAP combined ratio by 5.3 points in 2007, compared to 1.9 points in 2006.
  -   In 2007, the total favorable development impact of 6.6 points was offset by reserve strengthening of the catastrophic injury liability reserves which contributed 1.3 points of adverse development.
 
  -   In 2006, the total favorable development impact of 3.9 points was offset by reserve strengthening of the pre-1986 automobile catastrophic injury liability reserves which contributed 2.0 points of adverse development.
    Incurred catastrophe losses contributed only 1.7 points to the GAAP combined ratio in 2007, compared to 4.0 points in 2006.
Profitability measures
                           
      Years ended December 31,
      2007   2006   2005        
   
 
Erie Indemnity Company GAAP loss and LAE ratio(1)
    60.7       65.4       65.0  
 
Erie Indemnity Company GAAP combined ratio(1)
    88.1       93.7       93.1  
 
P&C Group statutory combined ratio
    87.7       93.5       90.5  
 
P&C Group adjusted statutory combined ratio(2)
    83.8       89.4       85.7  
 
Direct business:
                       
 
Personal lines adjusted statutory combined ratio
    83.9       90.6       88.6  
 
Commercial lines adjusted statutory combined ratio
    84.7       88.5       83.1
   
 
Prior accident year reserve development—(redundancy) deficiency
    (5.3 )     (1.9 )     1.2  
 
Prior year salvage and subrogation recoveries collected
    (1.7 )     (1.6 )     (1.5 )
   
 
Total loss ratio points from prior accident years
    (7.0 )     (3.5 )     (0.3 )
   
(1) The GAAP loss and LAE ratio and the combined ratio, expressed as a percentage, is the ratio of losses, loss adjustment, acquisition and other underwriting expenses incurred to earned premiums for our property/casualty insurance subsidiaries. Our GAAP combined ratios are different than the results of the Property and Casualty Group due to certain GAAP adjustments and the effects of the excess-of-loss reinsurance agreement between our property/casualty insurance subsidiaries and the Exchange. The excess-of-loss reinsurance agreement was terminated December 31, 2005.
(2) The adjusted statutory combined ratio removes the profit margin on the management fee we earn from the Property and Casualty Group.
Development of direct loss reserves
Our 5.5% share of the Property and Casualty Group’s favorable development of prior accident year losses, after removing the effects of salvage and subrogation recoveries, was $11.0 million in 2007 and improved the combined ratio by 5.3 points. Of the $11.0 million, $8.1 million related to the personal auto line of business. The Property and Casualty Group reduced reserves in 2007 on prior accident years as a result of sustained improved severity trends on

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automobile bodily injury and on uninsured/underinsured motorist (UM/UIM) bodily injury. Also in 2007, the Property and Casualty Group’s property damage and collision frequencies continued to improve along with severity trends on collision, medical coverage and comprehensive, while property damage severity began to rise. Overall, loss costs for private passenger auto have remained relatively flat, with the exception of bodily injury costs, which have increased.
In 2006, our share of the Property and Casualty Group’s positive development after removing the effects of salvage and subrogation recoveries was $4.0 million, and improved the combined ratio by 1.9 points. The total favorable development of 3.9 points was offset by 2.0 points, or $4.2 million for reserve strengthening of the pre-1986 automobile catastrophic injury liability reserve. The Property and Casualty Group’s favorable development in 2006 on prior accident years was the result of improved frequency trends for automobile bodily injury and uninsured/underinsured motorist bodily injury, predominantly from 2004 and 2005 accident years. In 2005, the adverse development of 1.2 points includes the effects of our share of adverse development in the pre-1986 automobile catastrophe liability reserve.
Catastrophe losses
Catastrophes are an inherent risk of the property/casualty insurance business and can have a material impact on our insurance underwriting results. In addressing this risk, we employ what we believe are reasonable underwriting standards and monitor our exposure by geographic region. The Property and Casualty Group maintains property catastrophe reinsurance coverage from unaffiliated insurers. Our property/casualty insurance subsidiaries previously had an all-lines excess-of-loss reinsurance agreement with the Exchange that was purchased to mitigate the effect of catastrophe losses on our financial position. The excess-of-loss agreement was not renewed for the 2006 and 2007 accident years due to the proposed pricing for the coverage as well as the loss profile of the Property and Casualty Group. The Property and Casualty Group maintains sufficient property catastrophe coverage from unaffiliated reinsurers and no longer participates in the assumed reinsurance business, which lowers the variability of the underwriting results of the Property and Casualty Group.
During 2007, 2006 and 2005, our share of catastrophe losses, as defined by the Property and Casualty Group, amounted to $3.6 million, $8.5 million and $1.2 million, respectively, or 1.7 points, 4.0 points and 0.5 points, respectively, of the loss ratio. The Property and Casualty Group’s actuarially projected average catastrophe level is about 6 loss ratio points per accident year. The catastrophe losses in 2007 resulted from wind and rainstorms in Ohio and Pennsylvania. Storm-related losses were closer to expected levels in 2006, with wind and hailstorms concentrated primarily in Indiana and Ohio driving a majority of these catastrophe losses. Catastrophe losses were well below expected levels in 2005. There was no impact on the Property and Casualty Group’s underwriting results from Hurricanes Katrina, Rita or Wilma during 2005.
Investment operations
                                           
      Years ended December 31,
              % Change           % Change    
              2007 over           2006 over    
  (in thousands)   2007   2006   2006   2005   2005
   
 
Net investment income
  $ 52,833       (5.5 )%   $ 55,920       (9.2 )%   $ 61,555  
 
Net realized (losses) gains on investments
    (5,192 )   NM     1,335       (91.5 )     15,620  
 
Equity in earnings of limited partnerships
    59,690       42.9     41,766       9.7     38,062  
 
Equity in earnings of EFL
    3,133       (32.0 )     4,604       26.6     3,636  
   
 
Net revenue from investment operations
  $ 110,464       6.6 %   $ 103,625       (12.8 )%   $ 118,873  
   
NM = not meaningful
Key points
    Net investment income decreased $3.1 million in 2007 as we continued to repurchase shares of our common stock. Funds used to repurchase treasury shares amounted to $236.7 million in 2007, compared to $217.4 million in 2006. Included in this 2007 amount are shares with a total cost of $99.0 million authorized separate from our repurchase program by our Board of Directors for repurchase from the F. William Hirt Estate.

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    Net realized losses on investments in 2007 include impairment charges of $22.5 million offset somewhat by gains on sales of common stock of $14.3 million. We realized higher gains in 2005 as we were selling common stock due to our transitioning to the use of external equity managers.
 
    Limited partnership earnings increased $17.9 million in 2007 primarily as a result of fair value appreciation from private equity partnerships and favorable fair value appreciation and earnings from our real estate limited partnerships.
 
    EFL’s decrease in net income in 2007 compared to 2006 resulted mainly from recognizing $11.1 million in impairment charges in its fixed maturity portfolio during 2007.
Investment income includes primarily interest and dividends on our fixed maturity and equity security portfolios. The decline in net investment income in 2007 and 2006 is primarily due to continued repurchases of our common stock under our stock repurchase program, which had increased activity. Investments were liquidated in the current year to help fund stock repurchases thus limiting the funds available for investment operations. The stock repurchase program runs through 2008.
Net realized losses or gains on investments primarily relate to gains and losses on bonds, preferred stock and common stock. Realized gains on sales of common stock, before consideration of impairment charges, were $14.3 million in 2007 and $6.7 million in 2006. Impairment losses are also a component of net realized losses or gains which totaled $22.5 million in 2007 compared to $6.4 million in 2006. Impairment charges in 2007 were primarily in issues in the banking and finance industries.
The performance of our fixed maturities and equity securities, compared to selected market indices, is presented as follows:
Pre-tax annualized returns
           
      Two years ended  
      December 31, 2007  
   
 
Fixed maturities—corporate(1)
    4.71 %
 
Fixed maturities—municipal(2)
    4.46  
 
Preferred stock(2)
    1.09  
 
Common stock(3)
    8.40  
 
Other indices:
       
 
Lehman Brothers—U.S. Aggregate
    5.64  
 
S&P 500 Composite Index
    10.50  
   
(1) See Item 7A. Quantitative and Qualitative Disclosure about Market Risk for a discussion of structured investments.
(2) Interest and dividends of municipal bonds and certain preferred stocks are tax exempt. The percentages in the table are actual yields, but do not incorporate the additional benefit received resulting from the tax advantage.
(3) Return is net of fees to external managers.

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The components of equity in earnings of limited partnerships are as follows:
                                           
      Years ended December 31,
              % Change           % Change    
              2007 over           2006 over    
  (in thousands)   2007   2006   2006   2005   2005
   
 
Private equity
  $ 22,948       22.9 %   $ 18,665       (18.9 )%   $ 23,027  
 
Real estate
    30,206       71.3     17,634       71.2     10,302  
 
Mezzanine debt
    6,536       19.6     5,467       15.5     4,733  
   
 
Total equity in earnings of limited partnerships
  $ 59,690       42.9 %   $ 41,766       9.7 %   $ 38,062  
   
Limited partnership earnings pertain to investments in U.S. and foreign private equity, real estate and mezzanine debt partnerships. Valuation adjustments are recorded to reflect the fair value of limited partnerships. These adjustments are recorded as a component of equity in earnings of limited partnerships in the Consolidated Statements of Operations in 2007 and 2006. Private equity and mezzanine debt limited partnerships generated earnings, excluding valuation adjustments, of $21.6 million, $15.3 million and $20.3 million in 2007, 2006 and 2005, respectively. Real estate limited partnerships included earnings of $15.6 million, $10.6 million and $7.7 million in 2007, 2006 and 2005, respectively. Limited partnerships experienced favorable earnings due to increased income earned in 2007 and 2006. Limited partnership earnings tend to be cyclical based on market conditions, the age of the partnership and the nature of the investments.
Provision for income taxes
Our 2007 effective income tax rate and provision was affected by a $1.6 million reduction for an adjustment to our December 31, 2006 provision estimates to the actual tax return and a reduction of $1.1 million in interest income related to the settlement of the IRS examinations for the years 2003 and 2004.
FINANCIAL CONDITION
Investments
Our 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. Our investment strategy also provides for liquidity to meet our short- and long-term commitments. At December 31, 2007 and 2006, our investment portfolio of investment-grade bonds, common stock, investment-grade preferred stock and cash and cash equivalents represents 31.4% and 36.2%, respectively, of total assets. These investments provide the liquidity we require to meet the demands on our funds.
Distribution of investments
                                   
      Carrying value at December 31,
 
  (in thousands)   2007   % to total   2006   % to total
   
 
Fixed maturities
  $ 703,406       57 %   $ 836,738       63 %
 
Equity securities:
                               
 
Preferred stock
    110,180       9     133,401       10
 
Common stock
    108,090       9     117,246       9
 
Limited partnerships:
                               
 
Real estate
    141,020       11     108,711       8
 
Private equity
    106,616       9     82,464       6
 
Mezzanine debt
    44,867       4     39,771       3
 
Real estate mortgage loans
    4,556       1     4,726       1
   
 
Total investments
  $ 1,218,735       100 %   $ 1,323,057       100 %
   
We continually review 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, including downgrades by the major rating agencies, are considered in evaluating impairment in

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value. Other factors considered in our review of investment valuation are the length of time the fair value is below cost and the amount the fair value is below cost.
Throughout 2007, we analyzed our impaired common equity securities to determine whether the decline was, in our opinion, significant and of an extended duration. We considered market conditions, industry characteristics and the fundamental operating results of the issuer to determine if the impairment was other-than-temporary and if so, we recognized an impairment charge to operations. At December 31, 2007, all common stock investments in an unrealized loss position were impaired and included in realized losses in the Consolidated Statements of Operations. See the “Equity Securities” section below.
For fixed maturity and preferred stock investments, we individually analyze all positions with emphasis on those that have, in our opinion, declined significantly below cost. We consider 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. A charge is recorded in the Consolidated Statements of Operations for positions that have experienced other-than-temporary impairments due to credit quality or other factors, or for which it is not our intent to hold the position until recovery has occurred.
Fixed maturities
Under our investment strategy, we maintain a fixed maturities portfolio that is of high quality and well diversified within each market sector. This investment strategy also 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. The fixed maturities portfolio is managed with the goal of achieving reasonable returns while limiting exposure to risk. The municipal bond portfolio accounts for $249.4 million, or 35.5%, of the total fixed maturity portfolio. The municipal portfolio is highly rated and includes all investment grade holdings (BBB or higher). The overall insured credit quality of the municipal portfolio is rated AAA. Insurance enhanced municipal bonds total $199.1 million, or 79.8%, of the municipal bond portfolio. The overall credit quality of our municipal bond portfolio giving no effect to insurance is rated A.
Fixed maturities classified as available-for-sale are carried at fair value with unrealized gains and losses, net of deferred taxes, included in shareholders’ equity. At December 31, 2007, the net unrealized gain on fixed maturities, net of deferred taxes, amounted to $0.6 million, compared to $4.3 million at December 31, 2006.
Equity securities
Our equity securities consist of common stock and nonredeemable preferred stock. Investment characteristics of common stock and nonredeemable preferred stock differ substantially from one another. Our nonredeemable preferred stock portfolio provides a source of highly predictable current income that is competitive with investment-grade bonds. Nonredeemable preferred stocks generally provide fixed or floating rates of dividends that, while not guaranteed, resemble fixed income securities and must be 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.
Our equity securities are carried at fair value on the Consolidated Statements of Financial Position. At December 31, 2007, the unrealized gain on equity securities, net of deferred taxes, amounted to $9.3 million, compared to $17.8 million at December 31, 2006.
During 2007 we decided to adopt FAS 159, effective January 1, 2008, for our common stock portfolio. As a result of adopting this standard, all changes in unrealized gains and losses on our Consolidated Statements of Financial Position will be reflected in our Consolidated Statements of Operations. A one-time cumulative-effect adjustment of approximately $11.2 million, net of tax, will be recorded as an increase to retained earnings with an offsetting reduction to other comprehensive income on January 1, 2008.
Limited partnership investments
During 2007, investments in limited partnerships increased $61.6 million to $292.5 million driven by fair value appreciation and capital additions. Mezzanine debt and real estate limited partnerships, which comprise 63.6% of the total limited partnerships, produce a more predictable earnings stream while private equity limited partnerships, which comprise 36.4% of the total limited partnerships, tend to provide a less predictable earnings stream but the potential for greater long-term returns.

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Shareholders’ equity
Adjustments are made to shareholders’ equity in accordance with Financial Accounting Standard (FAS) No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R).” This statement requires that we recognize the funded status of our postretirement benefit plans in the statement of financial position, with a corresponding adjustment to accumulated other comprehensive income, net of tax. At December 31, 2007, shareholders’ equity increased by $16.1 million, net of tax, of which $1.1 million represents amortization of the prior service cost and net actuarial loss and $15.0 million represents the current period actuarial loss. Shareholders’ equity decreased by $21.1 million, net of tax, at December 31, 2006, as a result of initially applying the recognition provisions of FAS 158.
Liabilities
Property/casualty loss reserves
Loss reserves are established to account for the estimated ultimate costs of loss and loss adjustment expenses for claims that have been reported but not yet settled and claims that have been incurred but not reported.
The factors which may potentially cause the greatest variation between current reserve estimates and the actual future paid amounts are: unforeseen changes in statutory or case law altering the amounts to be paid on existing claim obligations, new medical procedures and/or drugs with costs significantly different from those seen in the past, and claims patterns on current business that differ significantly from historical claims patterns.
Loss and loss adjustment expense reserves are presented on our Consolidated Statements of Financial Position on a gross basis for EIC, EINY and EIPC. Our property/casualty insurance subsidiaries wrote about 17% of the direct property/casualty premiums of the Property and Casualty Group in 2007. Under the terms of the Property and Casualty Group’s quota share and intercompany pooling arrangement, a significant portion of these reserve liabilities are recoverable. Recoverable amounts are reflected as an asset on our Statements of Financial Position. The direct and assumed loss and loss adjustment expense reserves by major line of business and the related amount recoverable under the intercompany pooling arrangement are presented as follows:
                   
      As of December 31,  
  (in thousands)   2007     2006  
   
 
Gross reserve liability:
               
 
Private passenger auto
  $ 321,320     $ 373,108    
 
Pre-1986 automobile catastrophic injury
    192,764       196,856  
 
Homeowners
    28,506       27,224  
 
Workers compensation
    146,402       221,078  
 
Workers compensation catastrophic injury
    108,589       0  
 
Commercial auto
    79,848       87,202  
 
Commercial multi-peril
    75,169       73,542  
 
All other lines of business
    73,933       94,560  
   
 
Gross reserves
    1,026,531       1,073,570  
 
Reinsurance recoverables(1)
    834,453       872,954  
   
 
Net reserve liability
  $ 192,078     $ 200,616  
   
(1) Includes $833.6 million in 2007 and $872.4 million in 2006 due from the Exchange.
The reserves that have the greatest potential for variation are the catastrophic injury liability reserves. There are currently about 300 claimants requiring lifetime medical care, of which less than 150 involve catastrophic injuries. During 2007, we began reserving for the workers compensation catastrophic injury reserves separately on a claim-by-claim basis. Prior to 2007, these reserves were estimated with the total population of workers compensation reserves. The reserve carried by the Property and Casualty Group for the catastrophic injury claimaints, which is our best estimate of this liability at this time, was $540.5 million at December 31, 2007, which is net of $176.3 million of anticipated reinsurance recoverables. Our property/casualty subsidiaries’ share of the net catastrophic injury liability reserves is $29.7 million at December 31, 2007.

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It is anticipated that these catastrophic injury claims will require payments over approximately the next 40 years. In 2007, we changed our mortality rate assumption to give 75% weight to our own mortality experience and 25% weight to the disabled pensioner mortality table. The impact on the pre-1986 automobile catastrophic injury liability reserves due to this change in methodology resulted in reserve strengthening of $35.7 million for the Property and Casualty Group, of which our property/casualty subsidiaries’ share was $2.0 million. The workers compensation catastrophic liability injury reserves were strengthened by $12.6 million for the Property and Casualty Group, and our property/casualty subsidiaries’ share was $0.7 million. In 2006, we changed our medical inflation rate assumption for these reserves from a flat 5% medical inflation assumption to a 10% annual increase in 2007 grading down 1% per year to an ultimate rate of 5%. A 100-basis point change in the medical cost inflation assumption would result in a change in net liability for us of $5.3 million. The claimants’ future life expectancy is another significant variable. The life expectancy assumption underlying the estimate reflects experience to date. Actual experience, different than that assumed, could have a significant impact on the reserve estimate. Our share of the catastrophic injury claim payments made was $0.9 million, $1.3 million and $0.8 million during 2007, 2006 and 2005, respectively.
At December 31, 2007, the Property and Casualty Group had estimated reserves related to the assumed loss and loss adjustment expense for the September 11, 2001 event of $22.1 million. The most critical factor in the estimation of these losses is whether the destruction of the World Trade Center Towers will be considered a single event or two separate events. This single or two event litigation is still pending, despite the fact that a significant amount of insurance claims related to the destruction of the World Trade Center Towers were settled in May 2007. We believe the current reserves should be sufficient to absorb the potential development.
IMPACT OF INFLATION
Property/casualty insurance premiums are established before losses and loss adjustment expenses, and therefore, before the extent to which inflation may impact such costs are known. Consequently, in establishing premium rates, we attempt to anticipate the potential impact of inflation.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity
Liquidity is a measure of an entity’s ability to secure enough cash to meet its contractual obligations and operating needs. Our major source of funds from operations are the net cash flows generated from management operations, the net cash flows from Erie Insurance Company’s and Erie Insurance Company of New York’s 5.5% participation in the underwriting results of the reinsurance pool with the Exchange, and investment income from affiliated and nonaffiliated investments.
We generate sufficient net positive cash flows from our operations to fund our commitments and make capital investments. We maintain a high degree of liquidity in our 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, 2007, 2006 and 2005, were $248.5 million, $270.4 million and $293.3 million, respectively.
With respect to the management fee, funds are received from the Exchange generally on a premiums-collected basis. We have a receivable from the Exchange and affiliates related to 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. We pay nearly all general and administrative expenses on behalf of the Exchange and other affiliated companies. The Exchange reimburses us for these expenses on a paid-basis quarterly.
Management fee and other cash settlements due at December 31 from the Exchange were $204.6 million and $224.3 million in 2007 and 2006, respectively. A receivable from EFL for cash settlements totaled $4.2 million at December 31, 2007, compared to $3.0 million at December 31, 2006. The receivable due from the Exchange for reinsurance recoverable from unpaid loss and loss adjustment expenses and unearned premium balances ceded to the intercompany reinsurance pool decreased 4.3% to $944.1 million from $986.5 million at December 31, 2007 and 2006, respectively. This decrease is the result of corresponding decreases in direct loss and loss adjustment expense reserves of our property/casualty insurance subsidiaries that are ceded to the Exchange under the intercompany pooling agreement. The amounts due us from the Exchange represented 22.1% of the Exchange’s total liabilities at December 31, 2007 and 2006.

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Cash flows provided by operating activities declined in 2007 primarily due to higher agent bonuses paid. Agent bonuses paid during 2007 increased $17.2 million compared to 2006, reflecting improved underwriting profitability of the Property and Casualty Group. Agent bonuses expected to be paid in 2008 that relate to the period ended in 2007 is $94.1 million. Pension funding and employee benefits paid increased as there was a $14.8 million contribution made to the employee pension plan in 2007 compared to an $8.1 million contribution in 2006. Beginning in 2007, our policy is to contribute at least the minimum required contribution that is in accordance with the Pension Protection Act of 2006. As our financial condition allows, we may consider additional contributions in any given year. For 2008, the expected contribution amount is $15.7 million which does exceed the minimum required amount. Our affiliated entities generally reimburse us about 50% of the net periodic benefit cost of the pension plan.
Salaries and wages paid during the year increased $11.8 million due to $3.2 million in additional compensation paid to our former president and chief executive officer and increases in average pay rates. Management fee revenues received were higher in 2007 due to the settlement of receivables. We paid $5.8 million in 2007, compared to $2.7 million in 2006, for the $50 private passenger auto bonus program implemented in 2006 which is estimated to be $3.3 million for 2008. Limited partnership distributions increased $16.7 million in 2007 due to fair value appreciation on these investments, which are accounted for under the equity method of accounting.
Cash flows provided by investing activities were $50.1 million in 2007 and $61.6 million in 2006, compared to cash used of $145.8 million in 2005. Proceeds from the sales, calls and maturities of fixed maturity positions totaled $266.0 million, $359.5 million and $348.0 million in 2007, 2006 and 2005, respectively. Proceeds from the sales of equity securities totaled $195.0 million, $146.1 million and $95.7 million in 2007, 2006 and 2005, respectively. At December 31, 2007, we had contractual commitments to invest up to $147.9 million related to our limited partnership investments. We expect to have sufficient distributions from existing limited partnerships and cash flows from operations to meet these commitments.
In spite of being publicly traded, some of our fixed income investments, particularly asset- and mortgage-backed securities, are illiquid due to credit market conditions. Further volatility in these markets could impair our ability to sell certain of our fixed income securities or the desirability of selling them at their current prices. We believe we have sufficient liquidity to meet our needs from other sources of cash flows even if credit market volatility persists throughout 2008.
In August 2007 we purchased 1.9 million shares of our Class A nonvoting common stock from the F. William Hirt Estate separate from our current stock repurchase program for a total cost of $99.0 million, or $52.04 per share. In conjunction with our stock repurchase plan, we repurchased 2.6 million shares at a total cost of $137.7 million in 2007 compared to 4.0 million shares repurchased in 2006 at a total cost of $217.4 million. In September 2007, our Board of Directors approved a continuation of this plan for an additional $100 million through December 2008. Approximately $92 million of outstanding repurchase authority remains under the program at December 31, 2007.
The increase in cash used in financing activities was largely the result of the share repurchase activity discussed above. Dividends paid to shareholders totaled $91.1 million, $86.1 million and $81.9 million in 2007, 2006 and 2005, respectively. Our capital management activities resulted in us increasing both our Class A and Class B shareholder quarterly dividends for 2007. There are no regulatory restrictions on the payment of dividends to our shareholders, although there are state law restrictions on the payment of dividends from our subsidiaries to us. Dividends have been approved at a 10.0% increase for 2008.
Contractual obligations
Cash outflows are variable because the fluctuations in settlement dates for claims payments vary and cannot be predicted with absolute certainty. While volatility in claims payments could be significant for the Property and Casualty Group, the effect of this volatility on our performance is mitigated by the intercompany reinsurance pooling arrangement. The cash flow requirements for claims have not historically had a significant effect on our liquidity. Based on a historical 15-year average, about 50% of losses and loss adjustment expenses included in the reserve are paid out in the subsequent 12-month period and approximately 89% are paid out within a five-year period. Losses that are paid out after that five-year period reflect such long-tail lines as workers compensation and auto bodily injury. Such payments are reduced by recoveries under the intercompany reinsurance pooling agreement.

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We have certain obligations and commitments to make future payments under various contracts. As of December 31, 2007, the aggregate obligations were as follows:
                                           
      Payments due by period  
                                      2013 and  
  (in thousands)   Total     2008     2009-2010     2011-2012     thereafter  
   
 
Fixed obligations:
 
Limited partnership commitments(1)
  $ 147,898     $ 55,449     $ 53,057     $ 39,392     $ 0  
 
Pension contribution(2)
    15,700       15,700       0       0       0  
 
Other commitments(3)
    27,730       12,429       10,507       4,794       0  
 
Operating leases—vehicles
    14,685       3,936       7,448       3,301       0  
 
Operating leases—real estate(4)
    6,116       2,742       2,824       550       0  
 
Operating leases—computers
    2,153       1,332       821       0       0  
 
Financing arrangements
    728       254       337       137       0  
   
 
Fixed contractual obligations
    215,010       91,842       74,994       48,174       0  
 
Gross loss and loss adjustment expense reserves
    1,026,531       513,266       301,800       100,600       110,865  
   
 
Gross contractual obligations(5)
  $ 1,241,541     $ 605,108     $ 376,794     $ 148,774     $ 110,865  
   
Gross contractual obligations net of estimated reinsurance recoverables and reimbursements from affiliates are as follows:
                                           
      Payments due by period  
                                      2013 and  
  (in thousands)   Total     2008     2009-2010     2011-2012     thereafter  
   
 
Gross contractual obligations(5)
  $ 1,241,541     $ 605,108     $ 376,794     $ 148,774     $ 110,865  
 
Estimated reinsurance recoverables
    834,453       417,227       245,329       81,776       90,121  
 
Estimated reimbursements from affiliates
    38,806       15,406       16,647       6,753       0  
   
 
Net contractual obligations
  $ 368,282     $ 172,475     $ 114,818     $ 60,245     $ 20,744  
   
(1) Limited partnership commitments will be funded as required for capital contributions at any time prior to the agreement expiration date. The commitment amounts are presented using the expiration date as the factor by which to age when the amounts are due. At December 31, 2007, the total commitment to fund limited partnerships that invest in private equity securities is $60.9 million, real estate activities $55.2 million and mezzanine debt of $31.8 million. We expect to have sufficient cash flows from operations and from positive cash flows generated from existing limited partnership investments to meet these partnership commitments.
(2) The pension contribution for 2008 was estimated in accordance with the Pension Protection Act of 2006. Contributions anticipated in future years are expected to be an amount at least equal to the IRS minimum required contribution in accordance with this Act.
(3) Other commitments include various agreements for service, including such things as computer software, telephones and maintenance.
(4) Operating leases—real estate are for 17 of our 23 field offices that are operated in the states in which the Property and Casualty Group does business and three operating leases are for warehousing facilities and remote office locations. One of the branch locations is leased from EFL.
(5) Gross contractual obligations do not include the obligations for our unfunded benefit plans, including the Supplemental Employee Retirement Plan (SERP) for our executive and senior management and the directors’ retirement plan. The recorded accumulated benefit obligations for these plans at December 31, 2007, are $16.1 million. We expect to have sufficient cash flows from operations to meet the future benefit payments as they become due. See also Item 8 “Financial Statements and Supplementary Data — Note 8 of Notes to Consolidated Financial Statements” contained within this report.
Off-balance sheet arrangements
Off-balance sheet arrangements include those with unconsolidated entities that may have a material current or future effect on our financial condition or results of operations, including material variable interests in unconsolidated entities that conduct certain activities. There are no off-balance sheet obligations related to our variable interest in the Exchange. Any liabilities between us and the Exchange are recorded in our Consolidated Statements of Financial Position. We have no material off-balance sheet obligations or guarantees.

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Financial ratings
Our property/casualty insurers are rated by rating agencies that provide insurance consumers with meaningful information on the financial strength of insurance entities. Higher ratings generally indicate financial stability and a strong ability to pay claims. The ratings are generally based upon factors relevant to policyholders and are not directed toward return to investors. The insurers of the Erie Insurance Group are currently rated by AM Best Company as follows:
         
 
  Erie Insurance Exchange   A+
 
  Erie Insurance Company   A+
 
  Erie Insurance Property and Casualty Company   A+
 
  Erie Insurance Company of New York   A+
 
  Flagship City Insurance   A+
 
  Erie Family Life Insurance   A
According to AM Best, a Superior rating (A+) is assigned to those companies that, in AM Best’s opinion, have achieved superior overall performance when compared to the standards established by AM Best and have a superior ability to meet their obligations to policyholders over the long term. The A (Excellent) rating of EFL continues to affirm its strong financial position, indicating that EFL has an excellent ability to meet its ongoing obligations to policyholders. By virtue of its affiliation with the Property and Casualty Group, EFL is typically rated one financial strength rating lower than the property/casualty companies by AM Best Company. The insurers of the Property and Casualty Group are also rated by Standard & Poor’s, but this rating is based solely on public information. Standard & Poor’s rates these insurers AApi, “Very Strong.” Financial strength ratings continue to be an important factor in evaluating the competitive position of insurance companies.
Regulatory risk-based capital
The standard set by the National Association of Insurance Commissioners (NAIC) for measuring the solvency of insurance companies, referred to as Risk-Based Capital (RBC), is a method of measuring the minimum amount of capital appropriate for an insurance company to support its overall business operations in consideration of its size and risk profile. The RBC formula is used by state insurance regulators as an early warning tool to identify, for the purpose of initiating regulatory action, insurance companies that potentially are inadequately capitalized. In addition, the formula defines minimum capital standards that will supplement the current system of low fixed minimum capital and surplus requirements on a state-by-state basis. At December 31, 2007, the companies comprising the Property and Casualty Group all had RBC levels substantially in excess of levels that would require regulatory action.
TRANSACTIONS AND AGREEMENTS WITH RELATED PARTIES
Board oversight
Our Board of Directors (Board) has broad oversight responsibility over intercompany relationships within Erie Insurance Group. As a consequence, the Board may be required to make decisions or take actions that may not be solely in the interest of our shareholders such as:
    setting the management fee rate paid by the Exchange to us;
 
    determining the continuation and participation percentages of the intercompany pooling agreement;
 
    approving the annual shareholders’ dividend; and
 
    ratifying any other significant intercompany activity, such as new cost-sharing agreements.
If the Board determines that the Exchange’s surplus requires strengthening, it could decide to reduce the management fee rate, change our property/casualty insurance subsidiaries’ intercompany pooling participation percentages or reduce or eliminate the shareholder dividends level in any given year. The Board could also decide, under such circumstances, that we should provide capital to the Exchange, although there is no legal obligation to do so.

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Intercompany agreements
Pooling
Members of the Property and Casualty Group participate in an intercompany reinsurance pooling agreement. Under the pooling agreement, all insurance business of the Property and Casualty Group is pooled in the Exchange. The Erie Insurance Company and Erie Insurance Company of New York share in the underwriting results of the reinsurance pool through retrocession. Since 1995, the Board of Directors has set the allocation of the pooled underwriting results at 5.0% participation for Erie Insurance Company, 0.5% participation for Erie Insurance Company of New York and 94.5% participation for the Exchange.
Leased property
The Exchange leases certain office facilities to us on a year-to-year basis. Rents are determined considering returns on invested capital and building operating and overhead costs. Rental costs of shared facilities are allocated based on square footage occupied.
Subscriber’s agreement
We serve as attorney-in-fact for the Exchange, a reciprocal insurance exchange. Each applicant for insurance to a reciprocal insurance exchange signs a subscriber’s agreement that contains an appointment of an attorney-in-fact. Through the designation of attorney-in-fact we are required to provide sales, underwriting and policy issuance services to the policyholders of the Exchange, as discussed previously.
Intercompany cost allocation
The allocation of costs affects the financial condition of the Erie Insurance Group companies. Management must determine that allocations are consistently made in accordance with intercompany management service agreements, the attorney-in-fact agreements with the policyholders of the Exchange and applicable insurance laws and regulations. While allocation of costs under these various agreements requires management judgment and interpretation, such allocations are performed using a consistent methodology, which in management’s opinion, adheres to the terms and intentions of the underlying agreements.
Intercompany receivables
                                   
              Percent of total           Percent of total
              Company           Company
  (in thousands)   2007   assets   2006   assets
   
 
Reinsurance recoverable from and ceded unearned premiums to the Exchange
  $ 944,078       32.8 %   $ 986,536       32.5 %
 
Other receivables from the Exchange and affiliates (management fees, costs and reimbursements)
    208,752       7.3       227,316       7.5  
 
Note receivable from EFL
    25,000       0.9     25,000       0.8
   
 
Total intercompany receivables
  $ 1,177,830       41.0 %   $ 1,238,852       40.8 %
   
We have significant receivables from the Exchange that result in a concentration of credit risk. These receivables include unpaid losses and unearned premiums ceded to the Exchange under the intercompany pooling agreement and from management services performed by us for the Exchange. The policyholder surplus of the Exchange at December 31, 2007, on a statutory accounting basis totaled almost $4.8 billion. Credit risks related to the receivables from the Exchange are evaluated periodically by our management. Reinsurance contracts do not relieve us from our primary obligations to policyholders if the Exchange were unable to satisfy its obligation. We collect our reinsurance recoverable amount generally within 30 days of actual settlement of losses.
We also have a receivable from the Exchange for management fees and costs we pay on behalf of the Exchange. We also pay certain costs for, and are reimbursed by, EFL. Since our inception, we have collected these amounts due from the Exchange and EFL in a timely manner (normally quarterly). There is interest charged on the outstanding balance due from the Exchange until its quarterly settlement that is based on an independent mutual fund rate.

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We have a surplus note for $25 million with EFL that is payable on demand on or after December 31, 2018. EFL paid interest to us on the surplus note totaling $1.7 million in both 2007 and 2006. No other interest is charged or received on these intercompany balances due to the timely settlement terms and nature of the items.
FACTORS THAT MAY AFFECT FUTURE RESULTS
Financial condition of the Exchange
We have a direct interest in the financial condition of the Exchange because management fee revenues are based on the direct written premiums of the Exchange and the other members of the Property and Casualty Group. Additionally, we participate in the underwriting results of the Exchange through the pooling arrangement in which our insurance subsidiaries have 5.5% participation. A concentration of credit risk exists related to the unsecured receivables due from the Exchange for certain fees, costs and reimbursements.
To the extent that the Exchange incurs underwriting losses or investment losses resulting from declines in the value of its marketable securities, the Exchange’s policyholders’ surplus would be adversely affected. If the surplus of the Exchange were to decline significantly from its current level, the Property and Casualty Group could find it more difficult to retain its existing business and attract new business. A decline in the business of the Property and Casualty Group would have an adverse effect on the amount of the management fees we receive and the underwriting results of the Property and Casualty Group. In addition, a significant decline in the surplus of the Exchange from its current level would make it more likely that the management fee rate would be reduced. A decline in surplus could also result from variability in investment markets as realized and unrealized losses are recognized.
Insurance premium rate actions
The changes in premiums written attributable to rate changes of the Property and Casualty Group directly affect direct written premium levels and underwriting profitability of the Property and Casualty Group, the Exchange and us. In 2007, the industry trend experienced by insurers was growing price competition. Rate reductions were implemented by the Property and Casualty Group in 2007 to recognize improved underwriting results and to be more price competitive. Following three years of premium rate reductions, the 2008 rate actions sought by the Property and Casualty Group are expected to be premium revenue neutral. Pricing actions contemplated or taken by the Property and Casualty Group are subject to various regulatory requirements of the states in which these insurers operate. The pricing actions already implemented, or to be implemented through 2008, will also have an effect on the market competitiveness of the Property and Casualty Group’s insurance products. Such pricing actions, and those of competitors, could affect the ability of our agents to sell and/or renew business. Management estimates that pricing actions approved, contemplated for filing and awaiting approval through 2007, could result in a net reduction to premiums for the Property and Casualty Group of $8.8 million in 2008.
The Property and Casualty Group continues refining its pricing segmentation model for private passenger auto and homeowners lines of business. The rating plan includes significantly more pricing segments than the former plan, providing us greater flexibility in pricing for policyholders with varying degrees of risk. Refining pricing segmentation should enable us to provide more competitive rates to policyholders with varying risk characteristics, as risks can be more accurately priced over time. The continued introduction of new pricing variables could impact retention of existing policyholders and could affect the Property and Casualty Group’s ability to attract new policyholders.
Policy growth
Premium levels attributable to growth in policies in force of the Property and Casualty Group directly affect the profitability of our management operations. In 2006 and 2007, the maturing of our pricing segmentation model has contributed to our growth in new policies in force and improved retention ratios. The continued growth of the policy base of the Property and Casualty Group is dependent upon its ability to retain existing and attract new policyholders. A lack of new policy growth or the inability to retain existing customers could have an adverse effect on the growth of premium levels for the Property and Casualty Group, and, consequently, lower management fees for us.

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Catastrophe losses
The Property and Casualty Group conducts business in 11 states and the District of Columbia, primarily in the mid-Atlantic, mid-western and southeastern portions of the United States. A substantial portion of the business is private passenger and commercial automobile, homeowners and workers compensation insurance in Ohio, Maryland, Virginia and, particularly, Pennsylvania. As a result, a single catastrophe occurrence or destructive weather pattern could materially adversely affect the results of operations and surplus position of the members of the Property and Casualty Group. Common catastrophe events include severe winter storms, hurricanes, earthquakes, tornadoes, wind and hail storms. In its homeowners line of insurance, the Property and Casualty Group is particularly exposed to an Atlantic hurricane, which might strike the states of North Carolina, Maryland, Virginia and Pennsylvania. The Property and Casualty Group maintains a property catastrophe reinsurance treaty with nonaffiliated reinsurers to mitigate the future potential catastrophe loss exposure. The property catastrophe reinsurance coverage in 2007 provided coverage of up to 95% of a loss of $400 million in excess of the Property and Casualty Group’s loss retention of $400 million per occurrence. This agreement was renewed for 2008 under the same terms of coverage while the Property and Casualty Group’s loss retention increased to $450 million per occurrence.
While the Property and Casualty Group is exposed to terrorism losses in commercial lines including workers compensation, these lines are afforded a limited backstop above insurer deductibles for foreign acts of terrorism under the newly enacted federal Terrorism Risk Insurance Program Reauthorization and Extension Act of 2007 that will continue through December 31, 2014. The Property and Casualty Group has no personal lines terrorism coverage in place. Although current models suggest the most likely occurrences would not have a material impact on the Property and Casualty Group, there is a chance that if future terrorism attacks occur, the Property and Casualty Group could incur large losses.
Incurred but not reported (IBNR) losses
The Property and Casualty Group is exposed to new claims on previously closed files and to larger than historical settlements on pending and unreported claims. We are exposed to increased losses by virtue of our 5.5% participation in the intercompany reinsurance pooling agreement with the Exchange. We exercise professional diligence to establish reserves at the end of each period that are fully reflective of the ultimate value of all claims incurred. However, these reserves are, by their nature, only estimates and cannot be established with absolute certainty.
The reserve that has the greatest potential for variation is the catastrophic injury liability reserve. The workers compensation product and the automobile no-fault law in Pennsylvania from 1975 until 1985 provided for unlimited medical benefits. The estimation of ultimate liabilities for these claims is subject to significant judgment due to variations in claimant health and mortality over time. Actual experience, different than that assumed, could have a significant impact on the reserve estimates.
Market volatility
With the adoption of FAS 159 as of January 1, 2008, all changes to unrealized gains and losses on the common stock portfolio will be recognized in investment income as net realized gains or losses in the Consolidated Statements of Operations. The fair value of the common stock portfolio is subject to fluctuation from period to period resulting from changes in prices. Depending upon market conditions, this could cause considerable fluctuation in reported total investment income in 2008 and beyond. See Item 7A. Quantitative and Qualitative Disclosures about Market Risk, Equity Price Risk herein for further information on the risk of market volatility.
Information technology development
During 2007 and continuing into 2008, we are carrying out a broad program of initiatives to enhance the functionality of our legacy processing and agency interface systems aimed at improving the ease of doing business, enhancing agent and employee productivity and access to information. We are also continuing in 2008 a program to evaluate policy administration system replacement alternatives which we initiated in 2007. The costs we would incur under the policy administration system development programs being evaluated are significant and depending on the development timeframe, could have a material impact on our reported earnings in 2008 and future years.

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Erie Family Life business process outsourcing
During 2006, Erie Family Life (EFL) decided to outsource certain business processes and core information technology to an external vendor beginning in 2007. The transition of functions and technology to the external vendor occurred in August 2007. EFL expected to incur substantial costs in 2007, due to the conversion and continued transition efforts, which impacts us 21.6% through our ownership share of EFL. EFL’s total conversion costs through December 31, 2007 were $5.5 million, of which our share was $1.2 million. Due to unforeseen complications in the outsource transition, business production in EFL has slowed since the outsourcing. EFL and Company management are in the process of remediation of these complications. To some extent, our relationship with our Agents has been disrupted by these complications which, if not rectified, could impact the amount of business they place with EFL and with the Property and Casualty Group. The disruptive effect incurred and potentially to be incurred cannot be reliably estimated.

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Item 7A. Quantitative and Qualitative Disclosures about Market Risk
Market risk
Market risk is the risk of loss arising from adverse changes in market rates and prices, such as interest rates, as well as other relevant market rate or price changes. The volatility and liquidity in the markets in which the underlying assets are traded directly influence market risk. The following is a discussion of our primary risk exposures, including interest rate risk, equity price risk and credit risk, and how those exposures are currently managed as of December 31, 2007.
Interest rate risk
We invest primarily in fixed maturity investments, which comprised 58% of invested assets at December 31, 2007. The value of the fixed maturity portfolio is subject to interest rate risk. As market interest rates decrease, the value of the portfolio goes up with the opposite holding true in rising interest rate environments. We do not hedge our exposure to interest rate risk since we have the capacity and intention to hold the fixed maturity positions until maturity. A common measure of the interest sensitivity of fixed maturity assets is modified duration, a calculation that utilizes maturity, coupon rate, yield and call terms to calculate an average age of the expected cash flows. The longer the duration, the more sensitive the asset is to market interest rate fluctuations. Convexity measures the rate of change of duration with respect to changes in interest rates. These factors are analyzed monthly to ensure that both the duration and convexity remain in the targeted ranges we established.
A sensitivity analysis is used to measure the potential loss in future earnings, fair values or cash flows of market-sensitive instruments resulting from one or more selected hypothetical changes in interest rates and other market rates or prices over a selected period. In our sensitivity analysis model, a hypothetical change in market rates is selected that is expected to reflect reasonably possible changes in those rates. The following pro forma information is presented assuming a 100-basis point increase in interest rates at December 31 of each year and reflects the estimated effect on the fair value of our fixed maturity investment portfolio. We used the modified duration of our fixed maturity investment portfolio to model the pro forma effect of a change in interest rates at December 31, 2007 and 2006.
Fixed maturities interest-rate sensitivity analysis
                   
  (in thousands)   As of December 31,
      2007   2006
   
 
Fair value of fixed income portfolio
  $ 703,406     $ 836,738  
 
Fair value assuming 100-basis point rise in interest rates
    676,733       807,841  
   
 
Modified duration
    3.80       3.95  
   
While the fixed income portfolio is sensitive to interest rates, the future principal cash flows that will be received are presented as follows by contractual maturity date. Actual cash flows may differ from those stated as a result of calls, prepayments or defaults. The $25 million surplus note due from EFL is included in the principal cash flows and is due in 2018.
           
  (in thousands)   December 31, 2007
   
 
Fixed maturities, including note from EFL:
       
 
2008
  $ 58,599  
 
2009
    66,157  
 
2010
    56,298  
 
2011
    55,426  
 
2012
    65,459  
 
Thereafter
    424,656  
   
 
Total
  $ 726,595  
   
 
Fair value
  $ 728,406  
   

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  (in thousands)   December 31, 2006
   
 
Fixed maturities, including note from EFL:
       
 
2007
  $ 46,628  
 
2008
    77,160  
 
2009
    79,955  
 
2010
    71,670  
 
2011
    67,772  
 
Thereafter
    502,477  
   
 
Total
  $ 845,662  
   
 
Fair value
  $ 861,738  
   
Equity price risk
Our 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. We do not hedge our exposure to equity price risk inherent in our equity investments. Our objective is to earn competitive relative returns by investing in a diverse portfolio of high-quality, liquid securities. Portfolio holdings are diversified across industries and among exchange-traded small- to large-cap stocks. We measure risk by comparing the performance of the marketable equity portfolio to benchmark returns such as the Standard & Poors (S&P) 500 Composite Index. Beta is a measure of a security’s systematic (non-diversifiable) risk, which is the percentage change in an individual security’s return for a 1% change in the return of the market. The average Beta for our common stock holdings was 1.16. Based on a hypothetical 20% reduction in the overall value of the stock market, the fair value of the common stock portfolio would decrease by approximately $24.6 million.
Credit risk
Our objective is to earn competitive returns by investing in a diversified portfolio of securities. Our portfolios of fixed maturity securities, nonredeemable preferred stock, mortgage loans and, to a lesser extent, short-term investments are subject to credit risk. This risk is defined as the potential loss in fair value resulting from adverse changes in the borrower’s ability to repay the debt. We manage this risk by performing upfront underwriting analysis and ongoing reviews of credit quality by position and for the fixed maturity portfolio in total. We do not hedge the credit risk inherent in our fixed maturity investments.
Generally, the fixed maturities in our portfolio are rated by external rating agencies. If not externally rated, we rate them internally on a basis consistent with that used by the rating agencies. We classify all fixed maturities as available-for-sale securities, allowing us to meet our liquidity needs and provide greater flexibility to appropriately respond to changes in market conditions. The following table shows our fixed maturity investments by S&P rating as of December 31, 2007:
                           
  (in thousands)   Amortized   Fair   Percent
  Comparable S&P Rating   cost   value   of total
   
 
AAA, AA, A
  $ 413,523     $ 416,062       59.2 %
 
BBB
    261,969       260,634       37.1
   
 
Total investment grade
    675,492       676,696       96.3
   
 
BB
    21,818       20,926       3.0
 
B
    1,790       2,071       0.3
 
CCC, CC, C
    2,618       2,631       0.3
 
D
    770       1,082       0.1
   
 
Total non-investment grade
    26,996       26,710       3.7
   
 
Total
  $ 702,488     $ 703,406       100.0 %
   
Approximately 5.0%, or $35.5 million, of our fixed income portfolio is invested in structured products which include mortgage-backed securities (MBS), collateralized debt and loan obligations (CDO and CLO), collateralized mortgage obligations (CMO), asset-backed (ABS) and credit-linked notes.

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Our structured product portfolio has an average rating of A+ or higher. We believe we have no direct exposure to the subprime residential mortgage market through investments in structured products. However, we have indirect exposure through bond and preferred stock investments in the financial service industry. We continually monitor these investments for material declines in quality and value. The table below contains the credit quality rating of our structured products as recorded at fair value. The total amortized cost of these holdings was $38.2 million at December 31, 2007.
(in thousands)
                                         
                            Credit   Total
            Commercial           linked   structured
Rating   MBS/CMO   MBS   CDO/CLO   notes   holdings
 
 
  at Fair value
AAA
  $ 4,371     $ 5,295     $ 2,307     $ 1,821     $ 13,794  
AA
    0       0       816       0       816  
A
    0       0       11,496       0       11,496  
BBB
    0       4,370       5,035       0       9,405  
     
 
  $ 4,371     $ 9,665     $ 19,654     $ 1,821     $ 35,511  
     
Our municipal bond portfolio accounts for $249.4 million, or 35.5 %, of the total fixed maturity portfolio. 79.8% of the total municipal bond portfolio is insured. This insurance guarantees the payment of principal and interest on a bond if the issuer defaults. Our municipal bond portfolio is highly rated and includes all investment grade holdings (BBB or higher). The overall credit quality rating of our municipal bond portfolio is AAA. The overall credit quality rating of our municipal bond portfolio giving no effect to insurance is A+. The following table presents an analysis of our municipal bond ratings at December 31, 2007.
                                                           
(in thousands)                
  (1)   (2)   (3)
Uninsured bonds   Insured bonds   Underlying rating of insured bonds
              Fair value               Fair value               Fair value
  Rating   Fair value   %   Rating   Fair value   %   Rating   Fair value   %
           
 
AAA
  $ 27,370       54.4  %         AAA   $ 199,053       100.0  %         AAA   $ 0       0.0  %  
 
AA
    18,278       36.3     AA     0       0.0     AA     88,009       44.2  
 
A
    3,675       7.3     A     0       0.0     A     108,526       54.5  
 
BBB
    993       2.0     BBB     0       0.0     BBB     2,518       1.3  
           
 
AA
  $ 50,316       100.0  %   AAA   $ 199,053       100.0  %   A+   $ 199,053       100.0  %
           
 
 
  (1) + (2)   (1) + (3)                    
Total bonds (with insured rating)   Total bonds (with underlying rating)                    
  Rating   Fair value   Fair value %   Rating   Fair value   Fair value %                    
                           
 
AAA
  $ 226,423       90.8  %   AAA   $ 27,370       11.0  %
 
AA
    18,278       7.3     AA     106,287       42.6                      
 
A
    3,675       1.5     A     112,201       45.0  
 
BBB
    993       0.4     BBB     3,511       1.4                      
                           
 
AAA
  $ 249,369       100.0  %   A+   $ 249,369       100.0  %
         
We are also exposed to a concentration of credit risk with the Exchange. See the section, “Transactions and Agreements with Related Parties,” for further discussion of this risk.

46


 

Item 8. Financial Statements and Supplementary Data
Report of Independent Registered Public Accounting Firm
on the Effectiveness of Internal Control over Financial Reporting
To the Board of Directors and Shareholders
  of Erie Indemnity Company
Erie, Pennsylvania
We have audited Erie Indemnity Company’s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Erie Indemnity Company’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Erie Indemnity Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statements of financial position of Erie Indemnity Company as of December 31, 2007 and 2006, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2007 of Erie Indemnity Company and our report dated February 22, 2008, expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Cleveland, Ohio
February 22, 2008

47


 

Report of Independent Registered Public Accounting Firm
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 as of December 31, 2007 and 2006, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2007. Our audits also included the financial statement schedules listed in the Index at Item 15(a). These consolidated 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 standards of the Public Company Accounting Oversight Board (United States). 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 that 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 consolidated financial position of Erie Indemnity Company at December 31, 2007 and 2006, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
As discussed in Note 8 to the consolidated financial statements, in 2006 the Erie Indemnity Company changed its method of accounting for post retirement benefit plans in accordance with the adoption of Statement of Financial Accounting Standards No. 158.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Erie Indemnity Company’s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 22, 2008, expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Cleveland, Ohio
February 22, 2008

48


 

ERIE INDEMNITY COMPANY
CONSOLIDATED STATEMENTS OF OPERATIONS
Years ended December 31, 2007, 2006 and 2005
(dollars in thousands, except per share data)
                         
    2007   2006   2005
Operating revenue
                       
Management fee revenue, net
  $ 894,981     $ 891,071     $ 888,558  
Premiums earned
    207,562       213,665       215,824  
Service agreement revenue
    29,748       29,246       20,568  
             
Total operating revenue
    1,132,291       1,133,982       1,124,950  
 
                       
Operating expenses
                       
Cost of management operations
    755,642       742,526       710,237  
Losses and loss adjustment expenses incurred
    125,903       139,630       140,386  
Policy acquisition and other underwriting expenses
    48,909       52,048       50,108  
             
Total operating expenses
    930,454       934,204       900,731  
 
                       
Investment income — unaffiliated
                       
Investment income, net of expenses
    52,833       55,920       61,555  
Net realized (losses) gains on investments
    (5,192 )     1,335       15,620  
Equity in earnings of limited partnerships
    59,690       41,766       38,062  
             
Total investment income — unaffiliated
    107,331       99,021       115,237  
             
Income before income taxes and equity in earnings of Erie Family Life Insurance
    309,168       298,799       339,456  
Provision for income taxes
    (99,137 )     (99,055 )     (111,733 )
Equity in earnings of Erie Family Life Insurance, net of tax
    2,914       4,281       3,381  
             
Net income
  $ 212,945     $ 204,025     $ 231,104  
             
 
                       
Net income per share
                       
Class A common stock — basic
  $ 3.80     $ 3.45     $ 3.69  
             
 
                       
Class A common stock — diluted
  $ 3.43     $ 3.13     $ 3.34  
             
Class B common stock — basic and diluted
  $ 572.98     $ 524.87     $ 558.34  
             
 
                       
Weighted average shares outstanding — basic
                       
Class A common stock
    55,928,177       58,827,987       62,392,860  
             
Class B common stock
    2,563       2,661       2,843  
             
Weighted average shares outstanding — diluted
                       
Class A common stock
    62,096,816       65,256,608       69,293,649  
             
Class B common stock
    2,563       2,661       2,843  
             
See accompanying notes to Consolidated Financial Statements.

49


 

ERIE INDEMNITY COMPANY
CONSOLIDATED STATEMENTS OF FINANCIAL POSITION
As of December 31, 2007 and 2006
(dollars in thousands, except per share data)
                 
    2007   2006
Assets
               
 
               
Investments
               
Fixed maturities at fair value (amortized cost of $702,488 and $830,061, respectively)
  $ 703,406     $ 836,738  
Equity securities at fair value (cost of $204,005 and $223,210, respectively)
    218,270       250,647  
Limited partnerships (cost of $235,886 and $200,166, respectively)
    292,503       230,946  
Real estate mortgage loans
    4,556       4,726  
         
Total investments
    1,218,735       1,323,057  
 
               
Cash and cash equivalents
    31,070       60,241  
Accrued investment income
    9,713       11,374  
Premiums receivable from policyholders
    243,612       247,187  
Federal income taxes recoverable
    1,451       9,092  
Reinsurance recoverable from Erie Insurance Exchange on unpaid losses and loss adjustment expenses
    833,554       872,388  
Ceded unearned premiums to Erie Insurance Exchange
    110,524       114,148  
Note receivable from Erie Family Life Insurance
    25,000       25,000  
Other receivables due from Erie Insurance Exchange and affiliates
    208,752       227,316  
Reinsurance recoverable from non-affiliates
    2,323       2,097  
Deferred policy acquisition costs
    16,129       16,197  
Equity in Erie Family Life Insurance
    59,046       57,162  
Securities lending collateral
    30,370       22,784  
Pension plan asset
    32,460       7,108  
Other assets
    55,884       44,210  
         
Total assets
  $ 2,878,623     $ 3,039,361  
         

50


 

ERIE INDEMNITY COMPANY
CONSOLIDATED STATEMENTS OF FINANCIAL POSITION
As of December 31, 2007 and 2006
(dollars in thousands, except per share data)
                 
    2007   2006
Liabilities and shareholders’ equity
               
 
               
Liabilities
               
Unpaid losses and loss adjustment expenses
  $ 1,026,531     $ 1,073,570  
Unearned premiums
    421,263       424,282  
Commissions payable and accrued
    122,473       126,077  
Agent bonuses
    94,458       90,556  
Securities lending collateral
    30,370       22,784  
Accounts payable and accrued expenses
    41,057       41,723  
Deferred executive compensation
    23,499       29,713  
Deferred income taxes
    14,598       8,343  
Dividends payable
    23,637       23,265  
Employee benefit obligations
    29,458       37,200  
         
Total liabilities
    1,827,344       1,877,513  
         
 
               
Shareholders’ equity
               
Capital stock:
               
Class A common, stated value $.0292 per share; authorized 74,996,930 shares; 68,277,600 and 68,224,800 shares issued, respectively; 53,338,937 and 57,776,329 shares outstanding, respectively
    1,991       1,990  
Class B common, convertible at a rate of 2,400 Class A shares for one Class B share, stated value $70 per share; 2,551 and 2,573 shares authorized, issued and outstanding, respectively
    179       180  
Additional paid-in capital
    7,830       7,830  
Accumulated other comprehensive income
    10,048       5,422  
Retained earnings
    1,740,174       1,618,656  
         
Total contributed capital and retained earnings
    1,760,222       1,634,078  
 
               
Treasury stock, at cost, 14,938,663 and 10,448,471 shares, respectively
    (708,943 )     (472,230 )
         
Total shareholders’ equity
    1,051,279       1,161,848  
         
Total liabilities and shareholders’ equity
  $ 2,878,623     $ 3,039,361  
         
See accompanying notes to Consolidated Financial Statements.

51


 

ERIE INDEMNITY COMPANY
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2007, 2006 and 2005
(dollars in thousands)
                         
    2007   2006   2005
Cash flows from operating activities
                       
Management fee received
  $ 906,691     $ 883,072     $ 891,965  
Service agreement fee received
    29,648       28,246       20,334  
Premiums collected
    207,491       211,976       214,592  
Settlement of commutation received from Exchange
    6,782       1,710       3,031  
Net investment income received
    55,031       62,616       66,274  
Limited partnership distributions
    78,960       62,240       62,684  
Dividends received from Erie Family Life Insurance
    0       899       1,799  
Salaries and wages paid
    (111,794 )     (100,000 )     (89,401 )
Pension contribution and employee benefits paid
    (31,989 )     (24,923 )     (4,376 )
Commissions paid to agents
    (434,465 )     (433,532 )     (442,981 )
Agents bonuses paid
    (91,955 )     (74,753 )     (46,883 )
General operating expenses paid
    (79,461 )     (81,656 )     (85,418 )
Losses paid
    (114,624 )     (117,124 )     (111,754 )
Loss adjustment expenses paid
    (19,817 )     (13,432 )     (14,560 )
Other underwriting and acquisition costs paid
    (48,132 )     (50,631 )     (47,281 )
Income taxes paid
    (103,905 )     (84,267 )     (124,749 )
             
Net cash provided by operating activities
    248,461       270,441       293,276  
             
 
                       
Cash flows from investing activities
                       
Purchase of investments:
                       
Fixed maturities
    (150,754 )     (225,867 )     (371,709 )
Equity securities
    (173,901 )     (116,872 )     (157,640 )
Limited partnerships
    (87,503 )     (107,879 )     (75,279 )
Sales/maturities of investments:
                       
Fixed maturity sales
    180,433       243,711       232,617  
Fixed maturity calls/maturities
    85,590       115,782       115,422  
Equity securities
    194,981       146,129       95,676  
Return on limited partnerships
    9,995       12,874       15,198  
Disposal (purchase) of property and equipment
    100       (4,938 )     (2,003 )
Net (distributions) collections on agent loans
    (8,805 )     (1,364 )     1,942  
             
Net cash provided by (used in) investing activities
    50,136       61,576       (145,776 )
             
 
                       
Cash flows from financing activities
                       
Purchase of treasury stock
    (236,713 )     (217,353 )     (98,966 )
Dividends paid to shareholders
    (91,055 )     (86,089 )     (81,929 )
Payment of note from Erie Family Life Insurance
    0       0       15,000  
Increase (decrease) in collateral from securities lending
    7,585       (8,046 )     30,831  
(Acquisition) redemption of securities lending collateral
    (7,585 )     8,046       (30,831 )
             
Net cash used in financing activities
    (327,768 )     (303,442 )     (165,895 )
             
 
                       
Net (decrease) increase in cash and cash equivalents
    (29,171 )     28,575       (18,395 )
Cash and cash equivalents at beginning of year
    60,241       31,666       50,061  
             
Cash and cash equivalents at end of year
  $ 31,070     $ 60,241     $ 31,666  
             
     See accompanying notes to Consolidated Financial Statements.

52


 

ERIE INDEMNITY COMPANY
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(dollars in thousands, except per share data)
                                                                   
                              Accumulated                
      Total                   other   Class A   Class B   Additional    
      shareholders’   Comprehensive   Retained   comprehensive   common   common   paid-in   Treasury
      equity   income   earnings   income   stock   stock   capital   stock
   
 
Balance, January 1, 2005
  $ 1,266,881             $ 1,354,181     $ 58,611     $ 1,970     $ 200     $ 7,830       ($155,911 )  
               
 
Comprehensive income:
                                                               
 
Net income
    231,104     $ 231,104       231,104                                          
 
Unrealized loss on securities, net of tax (Note 6)
    (36,933 )     (36,933 )             (36,933 )                                
 
Minimum pension liability adjustment, net of tax
    3       3               3                                  
                                                               
 
Comprehensive income
          $ 194,174                                                  
                                                               
 
Purchase of treasury stock
    (98,966 )                                                     (98,966 )
 
Conversion of Class B shares to Class A shares
                                  2       (2 )                
 
Dividends declared:
                                                               
 
Class A $1.335 per share
    (82,918 )             (82,918 )                                        
 
Class B $200.25 per share
    (569 )             (569 )                                        
   
 
Balance, December 31, 2005
  $ 1,278,602             $ 1,501,798     $ 21,681     $ 1,972     $ 198     $ 7,830       ($254,877 )
   
 
Comprehensive income:
                                                               
 
Net income
    204,025     $ 204,025       204,025                                          
 
Unrealized gain on securities, net of tax (Note 6)
    4,804       4,804               4,804                                  
                                                               
 
Comprehensive income
          $ 208,829                                                  
                                                               
 
Adjustment to initially recognize funded status of employee benefit obligations, net of tax under FAS 158
    (21,063 )                     (21,063 )                                
 
Purchase of treasury stock
    (217,353 )                                                     (217,353 )
 
Conversion of Class B shares to Class A shares
                                  18       (18 )                
 
Dividends declared:
                                                               
 
Class A $1.48 per share
    (86,581 )             (86,581 )                                        
 
Class B $222.00 per share
    (586 )             (586 )                                        
   
 
Balance, December 31, 2006
  $ 1,161,848             $ 1,618,656     $ 5,422     $ 1,990     $ 180     $ 7,830       ($472,230 )
   
 
Comprehensive income:
                                                               
 
Net income
    212,945     $ 212,945       212,945                                          
 
Other comprehensive income:
 
Unrealized loss on securities, net of tax (Note 6)
    (11,427 )     (11,427 )             (11,427 )                                
 
Postretirement plans:
                                                               
 
Prior service cost, net of tax
    222       222               222                                  
 
Net actuarial gain, net of tax (Note 6)
    12,901       12,901               12,901                                  
 
Loss due to amendments, net of tax
    (867 )     (867 )             (867 )                                
 
Curtailment/settlement gain, net of tax
    3,797       3,797               3,797                                  
                                                       
 
Postretirement plans, net of tax
    16,053       16,053               16,053                                  
                                                       
 
Comprehensive income
          $ 217,571                                                  
                                                               
 
Purchase of treasury stock
    (236,713 )                                                     (236,713 )
 
Conversion of Class B shares to Class A shares
                                  1       (1 )                
 
Dividends declared:
                                                               
 
Class A $1.64 per share
    (90,797 )             (90,797 )                                        
 
Class B $246.00 per share
    (630 )             (630 )                                        
   
 
Balance, December 31, 2007
  $ 1,051,279             $ 1,740,174     $ 10,048     $ 1,991     $ 179     $ 7,830       ($708,943 )
   

53


 

ERIE INDEMNITY COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
     
Note 1.
  Nature of business
 
   
 
 
We are the attorney-in-fact for the subscribers of Erie Insurance Exchange (Exchange), a reciprocal insurance exchange. We perform certain services for the Exchange relating to the sales, underwriting and issuance of policies on behalf of the Exchange and earn a management fee for these services. The Exchange is a Pennsylvania-domiciled property/casualty insurer rated A+ (Superior) by A. M. Best. The Exchange is the 21st largest property/casualty insurer in the United States based on 2007 net premiums written for all lines of business. The Exchange and its wholly-owned subsidiary, Flagship City Insurance Company (Flagship) and our wholly-owned subsidiaries, Erie Insurance Company (EIC), Erie Insurance Company of New York (EINY) and the Erie Insurance Property and Casualty Company (EIPC), comprise the Property and Casualty Group. The Property and Casualty Group is a regional insurance group operating in 11 midwestern, mid-Atlantic, and southeastern states and the District of Columbia. The Property and Casualty Group primarily writes personal auto insurance, which comprises almost 48% of its direct premiums. Members of the Property and Casualty Group are subject to statutory regulations and are required to file reports in accordance with statutory accounting principles with the regulatory authorities. We also own 21.6% of the common stock of the Erie Family Life Insurance Company (EFL), an affiliated life insurance company; the Exchange owns the remaining 78.4%. We, together with the Property and Casualty Group and EFL, operate collectively as the Erie Insurance Group (Group).
 
   
Note 2.
  Recent accounting pronouncements
 
   
 
 
In February 2007, the Financial Accounting Standards Board (FASB) issued Financial Accounting Standard (FAS) 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” FAS 159 allows us the option to report selected financial assets and liabilities at fair value. FAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement bases for similar types of assets and liabilities. We have chosen to adopt the fair value option for our common stock portfolio as of January 1, 2008. These assets are currently accounted for as available-for-sale under FAS 115, “Accounting for Certain Investments in Debt and Equity Securities,” with unrealized gains and losses included in other comprehensive income. Upon adoption, the changes to unrealized gains and losses related to common stock will flow through the Consolidated Statements of Operations. The adoption of FAS 159 requires the unrealized gains and losses on these securities to be included in a cumulative effect adjustment to beginning retained earnings at January 1, 2008. The net impact of the cumulative effect adjustment for our common stock portfolio on January 1, 2008 is expected to increase retained earnings and reduce other comprehensive income by $11.2 million, net of tax.
 
   
 
 
In September 2006, the FASB issued FAS 157, “Fair Value Measurements,” which provides guidance for using fair value to measure assets and liabilities and enhances disclosures about fair value measurements. The standard applies whenever other standards require, or permit, assets or liabilities to be measured at fair value. The standard does not expand the use of fair value in any new circumstances. The statement establishes a fair value hierarchy that prioritizes the observable and unobservable inputs to valuation techniques used to measure fair value into three levels. Quantitative and qualitative disclosures will focus on the inputs used to measure fair value for fair value measurements and the effects of these measurements in the financial statements. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years.

54


 

ERIE INDEMNITY COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
     
Note 2.
  Recent accounting pronouncements (continued)
 
   
 
 
We are currently evaluating impacts of this standard on our interim and annual footnote disclosures. However, FAS 157 does not change any of our investment valuation policies and will not have an impact on our financial position, results of operations or cash flows.
 
   
Note 3.
  Significant accounting policies
 
   
 
  Basis of presentation
 
   
 
 
The accompanying consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles (GAAP) that differ from statutory accounting practices prescribed or permitted for insurance companies by regulatory authorities. See also Note 17.
 
   
 
  Principles of consolidation
 
   
 
 
The consolidated financial statements include our accounts and those of our wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.
 
   
 
  Reclassifications
 
   
 
 
Certain amounts reported in prior years have been reclassified to conform to the current year’s financial statement presentation.
 
   
 
  Use of estimates
 
   
 
 
The preparation of financial statements in conformity with U.S. generally accepted accounting principles 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.
 
   
 
  Investments
 
   
 
 
Available-for-sale securities — Fixed maturities and equity securities are classified as available-for-sale and include those securities that management intends to hold for indefinite periods, but which may be sold in response to changes in interest rates, tax planning considerations or other aspects of asset/liability management.
 
   
 
 
Fixed maturities, consisting of bonds, notes and redeemable preferred stock, are reported at fair value. Fair values of fixed income investments are based on prices quoted in the most active market for each security or dealer quote. If quoted market prices or dealer quotes are not available, fair value is estimated based on discounted expected cash flows using market rates commensurate with the credit quality and maturity of the investment. Premiums and discounts on mortgage-backed securities are amortized using the constant effective yield method adjusted for anticipated prepayments and the estimated economic life of the securities. Prepayment assumptions are reviewed periodically and adjusted to reflect actual prepayments and changes in expectations. Adjustments related to changes in prepayment assumptions are included as part of investment income.
 
   
 
 
Equity securities, which include common and nonredeemable preferred stocks, are carried at fair value based on quoted market prices.

55


 

ERIE INDEMNITY COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
     
Note 3.
  Significant accounting policies (continued)
 
   
 
 
Interest and dividend income are recognized as earned. The amortized cost of debt securities is adjusted for amortization of premiums and accretion of discounts to lowest yield which is included in investment income.
 
   
 
 
Unrealized holding gains and losses, net of related tax effects, on fixed maturities and preferred stock are charged or credited directly to shareholders’ equity as accumulated other comprehensive income. At December 31, 2007 we impaired all common stock securities in an unrealized loss position through the Consolidated Statements of Operations. See Note 5 for further discussion.
 
   
 
 
Limited partnerships — Limited partnerships include U.S. and foreign private equity, real estate and mezzanine debt investments. The private equity limited partnerships invest primarily in small- to medium-sized companies. Limited partnerships are recorded using the equity method.
 
   
 
 
Realized gains and losses — Realized gains and losses on sales of investments are recognized in income based upon the specific identification method.
 
   
 
 
Other-than-temporary impairments — All investments are evaluated monthly for other-than-temporary impairment loss. Some factors considered in evaluating whether or not a decline in fair value is other-than-temporary include:
 
   
 
 
   the extent and duration to which fair value is less than cost;
 
   
 
 
   historical operating performance and financial condition of the issuer;
 
   
 
 
   short and long-term prospects of the issuer and its industry based on analysts’ recommendations;
 
   
 
 
   specific events that occurred affecting the issuer, including a ratings downgrade; and
 
   
 
 
   our ability and intent to hold the investment for a period of time sufficient to allow for a recovery in value.
 
   
 
 
An investment that is deemed impaired is written down to its estimated fair value. Impairment charges are included in realized losses in the Consolidated Statements of Operations.
 
   
 
  Insurance liabilities
 
   
 
 
The liability for losses and loss adjustment expenses includes estimates for claims that have been reported and those that have been incurred but not reported, and estimates of all expenses associated with processing and settling these claims. Estimating the ultimate cost of future losses and loss adjustment expenses is an uncertain and complex process. This estimation process is based significantly on the assumption that past developments are an appropriate indicator of future events, and involves a variety of actuarial techniques that analyze experience, trends and other relevant factors. The uncertainties involved with the reserving process include internal factors, such as changes in claims handling procedures, as well as external factors, such as economic trends and changes in the concepts of legal liability and damage awards. Accordingly, final loss settlements may vary from the present estimates, particularly when those payments may not occur until well into the future.
 
   
 
 
We regularly review the adequacy of our estimated loss and loss adjustment expense reserves by line of business. Adjustments to previously established reserves are reflected in the operating results of the period in which the adjustment is determined to be necessary. Such adjustments could possibly be significant, reflecting any variety of new and adverse or favorable trends.

56


 

ERIE INDEMNITY COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
     
Note 3.
  Significant accounting policies (continued)
 
   
 
 
Loss reserves are set at full expected cost, except for workers compensation loss reserves, which have been discounted using an interest rate of 2.5%. Unpaid losses and loss adjustment expenses in the Consolidated Statements of Financial Position were reduced by $5.5 million and $5.0 million at December 31, 2007 and 2006, respectively, due to discounting. The reserves for losses and loss adjustment expenses are reported net of receivables for salvage and subrogation of $6.8 million at December 31, 2007 and 2006.
 
   
 
  Recognition of management fee revenue
 
   
 
 
We earn management fees from the Exchange for providing sales, underwriting and policy issuance services. The management fee revenue is calculated as a percentage of the direct written premium of the Property and Casualty Group. The Exchange issues policies with annual terms only. Management fees are recorded as revenue upon policy issuance or renewal, as substantially all of the services required to be performed by us have been satisfied at that time. Certain activities are performed and related costs are incurred by us subsequent to policy issuance in connection with the services provided to the Exchange; however, these activities are inconsequential and perfunctory.
 
   
 
 
Although we are not required to do so under the subscriber’s agreement with the Exchange, we return the management fee charged the Exchange when mid-term policy cancellations occur for the unearned premium on the policy. We estimate mid-term policy cancellations and record a related allowance which is adjusted quarterly. The effect of recording changes in this estimated allowance increased our management fee revenue by $.8 million, $1.5 million and $.5 million for the years ended December 31, 2007, 2006 and 2005, respectively, due to changes in the allowance.
 
   
 
  Recognition of premium revenues and losses
 
   
 
 
Insurance premiums written are earned over the terms of the policies on a pro-rata basis. Unearned premiums represent that portion of premiums written which is applicable to the unexpired terms of policies in force. Losses and loss adjustment expenses are recorded as incurred. Premiums earned and losses and loss adjustment expenses incurred are reflected net of amounts ceded to the Exchange on the Consolidated Statements of Operations. See also Note 16.
 
   
 
  Recognition of service agreement revenue
 
   
 
 
Included in service agreement revenue are service charges we collect from policyholders for providing multiple payment plans on policies written by the Property and Casualty Group. Service charges, which are flat dollar charges for each installment billed beyond the first installment, are recognized as revenue when bills are rendered to the policyholder.
 
   
 
  Agent bonus estimates
 
   
 
 
Agent bonuses are based on an individual agency’s property/casualty underwriting profitability and also include a component for growth in agency property/casualty premiums if the agency’s underwriting profitability targets for our book of business are met. The estimate for agent bonuses, which are based on the performance over 36 months, is modeled on a monthly basis using actual underwriting data by agency for the two prior years combined with the current year-to-date actual data and projected underwriting data for the remainder of the current year. At December 31 of each year, we use actual data available and record an accrual based on the expected payment amount. These costs are included in the cost of management operations in the Consolidated Statements of Operations.

57


 

ERIE INDEMNITY COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
     
Note 3.
  Significant accounting policies (continued)
 
   
 
  Income taxes
 
   
 
 
Provisions for income taxes include deferred taxes resulting from changes in cumulative temporary differences between the tax basis and financial statement basis of assets and liabilities. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.
 
   
Note 4.
  Earnings per share
 
   
 
 
Basic earnings per share are calculated under the two-class method, which allocates earnings to each class of stock based on its dividend rights. See Note 11. Class B shares are convertible into Class A shares at a conversion ratio of 2,400 to 1. The computation of Class A diluted earnings per share reflects the potentially dilutive effect of outstanding employee stock-based awards under the long-term incentive plan and awards not yet vested related to the outside directors’ stock compensation plan. See Note 9.
 
   
 
 
A reconciliation of the numerators and denominators used in the basic and diluted per-share computations is presented below for each class of common stock.
                                                                         
    For the years ended December 31,  
(dollars in thousands,   2007     2006     2005  
except per share data)   Allocated     Weighted     Per-     Allocated     Weighted     Per-     Allocated     Weighted     Per-  
    net income     shares     share     net income     shares     share     net income     shares     share  
    (numerator)     (denominator)     amount     (numerator)     (denominator)     amount     (numerator)     (denominator)     amount  
     
Class A - Basic EPS:
                                                                       
Income available to Class A stockholders
  $ 211,477       55,928,177     $ 3.80     $ 202,635       58,827,987     $ 3.45     $ 229,517       62,392,860     $ 3.69  
     
 
                                                                       
Dilutive effect of stock awards
    0       17,439             0       42,221             0       77,589        
     
 
                                                                       
Assumed conversion of Class B shares
    1,468       6,151,200             1,390       6,386,400             1,587       6,823,200        
     
 
                                                                       
Class A - Diluted EPS Income available to Class A stockholders on Class A equivalent shares
  $ 212,945       62,096,816     $ 3.43     $ 204,025       65,256,608     $ 3.13     $ 231,104       69,293,649     $ 3.34  
     
 
                                                                       
Class B - Basic and diluted EPS:
                                                                       
Income available to Class B stockholders
  $ 1,468       2,563     $ 572.98     $ 1,390       2,661     $ 524.87     $ 1,587       2,843     $ 558.34  
     

58


 

ERIE INDEMNITY COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
     
Note 5.
  Investments
 
   
 
  The following tables summarize the cost and fair value of available-for-sale securities at December 31, 2007 and 2006:
                                   
      December 31, 2007
      Amortized   Gross unrealized   Gross unrealized   Estimated
  (in thousands)   cost   gains   losses   fair value
 
Fixed maturities
                               
 
U.S. treasuries and government agencies
  $ 4,406     $ 272     $ 0     $ 4,678  
 
Municipal securities
    247,412       2,314       358       249,368  
 
U.S. corporate debt
    324,218       5,231       5,921       323,528  
 
Foreign corporate debt
    83,335       2,175       1,106       84,404  
 
Mortgage-backed securities
    11,565       602       38       12,129  
 
Asset-backed securities
    16,329       0       2,189       14,140  
 
 
               
 
Total bonds
    687,265       10,594       9,612       688,247  
 
Redeemable preferred stock
    15,223       614       678       15,159  
 
 
               
 
Total fixed maturities
  $ 702,488     $ 11,208     $ 10,290     $ 703,406  
 
 
               
 
Equity securities
                               
 
U.S. common stock
  $ 66,449     $ 12,754     $ 0     $ 79,203  
 
Foreign common stock
    24,408       4,549       70       28,887  
 
U.S. nonredeemable preferred stock
    108,018       1,978       4,960       105,036  
 
Foreign nonredeemable preferred stock
    5,130       250       236       5,144  
 
 
               
 
Total equity securities
  $ 204,005     $ 19,531     $ 5,266     $ 218,270  
 
 
               
                                   
      December 31, 2006  
      Amortized     Gross unrealized     Gross unrealized     Estimated
  (in thousands)   Cost     gains     losses     fair value
 
Fixed maturities
                               
 
U.S. treasuries and government agencies
  $ 3,765     $ 159     $ 45     $ 3,879  
 
Municipal securities
    330,239       2,935       1,561       331,613  
 
Foreign government
    2,000       9       0       2,009  
 
U.S. corporate debt
    357,177       5,754       3,196       359,735  
 
Foreign corporate debt
    82,929       2,166       563       84,532  
 
Mortgage-backed securities
    14,611       405       295       14,721  
 
Asset-backed securities
    18,117       37       64       18,090  
 
 
               
 
Total bonds
    808,838       11,465       5,724       814,579  
 
Redeemable preferred stock
    21,223       1,036       100       22,159  
 
 
               
 
Total fixed maturities
  $ 830,061     $ 12,501     $ 5,824     $ 836,738  
 
 
               
 
Equity securities
                               
 
U.S. common stock
  $ 71,932     $ 17,156     $ 785     $ 88,303  
 
Foreign common stock
    23,106       5,897       60       28,943  
 
U.S. nonredeemable preferred stock
    123,042       5,378       565       127,855  
 
Foreign nonredeemable preferred stock
    5,130       416       0       5,546  
 
 
               
 
Total equity securities
  $ 223,210     $ 28,847     $ 1,410     $ 250,647  
 
 
               

59


 

ERIE INDEMNITY COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
     
Note 5.
  Investments (continued)
 
   
 
 
The amortized cost and estimated fair value of fixed maturities at December 31, 2007, are shown below by remaining contractual term to maturity. Mortgage-backed securities are allocated based on 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.
                 
    Amortized   Estimated
(in thousands)   cost   fair value
 
               
Due in one year or less
  $ 58,568     $ 57,912  
Due after one year through five years
    239,911       240,880  
Due after five years through ten years
    293,267       295,360  
Due after ten years
    110,742       109,254  
 
       
Total fixed maturities
  $ 702,488     $ 703,406  
 
       

60


 

ERIE INDEMNITY COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
     
Note 5.
  Investments (continued)
 
   
 
  Fixed maturities and equity securities in a gross unrealized loss position are as follows. Data is provided by length of time securities were in a gross unrealized loss position.
                                                           
  (dollars in thousands)   Less than 12 months   12 months or longer   Total
      Fair   Unrealized   Fair   Unrealized   Fair   Unrealized   No. of
  December 31, 2007   value   losses   value   losses   value   losses   holdings
 
Fixed maturities
                                                       
 
U.S. treasuries and government agencies
  $ 353     $ 1     $ 0     $ 0     $ 353     $ 1       1  
 
Municipal securities
    25,268       114       32,905       244       58,173       358       29  
 
U.S. corporate debt
    81,945       3,509       72,926       2,412       154,871       5,921       101  
 
Foreign corporate debt
    20,826       769       12,051       336       32,877       1,105       22  
 
Mortgage-backed securities
    1,001       6       1,204       32       2,205       38       4  
 
Asset-backed securities
    9,770       1,559       4,370       630       14,140       2,189       10  
 
 
                           
 
Total bonds
    139,163       5,958       123,456       3,654       262,619       9,612       167  
 
Redeemable preferred stock
    2,460       540       4,997       138       7,457       678       2  
 
 
                           
 
Total fixed maturities
  $ 141,623     $ 6,498     $ 128,453     $ 3,792     $ 270,076     $ 10,290       169  
 
 
                           
 
 
                                                       
 
Equity securities
                                                       
 
Common stock
  $ 1,584     $ 70     $ 0     $ 0     $ 1,584     $ 70       4  
 
Nonredeemable preferred stock
    52,801       5,103       1,956       93       54,757       5,196       28  
 
 
                           
 
Total equity securities
  $ 54,385     $ 5,173     $ 1,956     $ 93     $ 56,341     $ 5,266       32  
 
 
                           
Quality breakdown of fixed maturities
                                                           
  (dollars in thousands)   Less than 12 months   12 months or longer   Total
      Fair   Unrealized   Fair   Unrealized   Fair   Unrealized   No. of
  December 31, 2007   value   losses   value   losses   value   losses   holdings
 
Investment grade
  $ 136,565     $ 6,111     $ 118,779     $ 2,925     $ 255,344     $ 9,036       158  
 
Non-investment grade
    5,058       387       9,674       867       14,732       1,254       11  
 
 
                           
 
Total fixed maturities
  $ 141,623     $ 6,498     $ 128,453     $ 3,792     $ 270,076     $ 10,290       169  
 
 
                           

61


 

ERIE INDEMNITY COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
     
Note 5.
  Investments (continued)
                                                           
  (dollars in thousands)   Less than 12 months   12 months or longer   Total
      Fair   Unrealized   Fair   Unrealized   Fair   Unrealized   No. of
  December 31, 2006   value   losses   value   losses   value   losses   holdings
 
Fixed maturities
                                                       
 
U.S. treasuries and government agencies
  $ 1,085     $ 28     $ 787     $ 17     $ 1,872     $ 45       5  
 
Municipal securities
    82,131       452       71,914       1,109       154,045       1,561       73  
 
U.S. corporate debt
    62,088       458       128,732       2,738       190,820       3,196       116  
 
Foreign corporate debt
    14,738       89       18,132       474       32,870       563       18  
 
Mortgage-backed securities
    1,312       2       6,092       293       7,404       295       12  
 
Asset-backed securities
    2,526       24       4,960       40       7,486       64       4  
 
 
                           
 
Total bonds
    163,880       1,053       230,617       4,671       394,497       5,724       228  
 
Redeemable preferred stock
    0       0       5,035       100       5,035       100       1  
 
 
                           
 
Total fixed maturities
  $ 163,880     $ 1,053     $ 235,652     $ 4,771     $ 399,532     $ 5,824       229  
 
 
                           
 
 
                                                       
 
Equity securities
                                                       
 
Common stock
  $ 11,934     $ 845     $ 0     $ 0     $ 11,934     $ 845       46  
 
Nonredeemable preferred stock
    13,109       295       6,277       270       19,386       565       10  
 
 
                           
 
Total equity securities
  $ 25,043     $ 1,140     $ 6,277     $ 270     $ 31,320     $ 1,410       56  
 
 
                           
Quality breakdown of fixed maturities
                                                           
  (dollars in thousands)   Less than 12 months   12 months or longer   Total
      Fair   Unrealized   Fair   Unrealized   Fair   Unrealized   No. of
  December 31, 2006   value   losses   value   losses   value   losses   holdings
 
Investment grade
  $ 163,880     $ 1,053     $ 227,361     $ 4,463     $ 391,241     $ 5,516       223  
 
Non-investment grade
    0       0       8,291       308       8,291       308       6  
 
 
                           
 
Total fixed maturities
  $ 163,880     $ 1,053     $ 235,652     $ 4,771     $ 399,532     $ 5,824       229  
 
 
                           
Investment income, net of expenses, was generated from the following portfolios for the years ended December 31 as follows:
                           
  (in thousands)   2007   2006   2005
 
 
                       
 
Fixed maturities
  $ 42,547     $ 44,438     $ 50,222  
 
Equity securities
    10,619       11,222       10,847  
 
Cash equivalents and other
    2,002       2,389       2,113  
 
 
           
 
Total investment income
    55,168       58,049       63,182  
 
Less: investment expenses
    2,335       2,129       1,627  
 
 
           
 
Investment income, net of expenses
  $ 52,833     $ 55,920     $ 61,555  
 
 
           

62


 

ERIE INDEMNITY COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
     
Note 5.
  Investments (continued)
 
   
 
   
 
  Following are the components of net realized gains on investments as reported in the Consolidated Statements of Operations. The 2007 fixed maturity impairment charges related to bonds in the consumer products industry. Included in the impairment charges on equity securities are $8.8 million of preferred stock impairments primarily in the finance industry. Common stock impairments were $7.0 million for the fourth quarter of 2007 and $8.5 million for the year.
 
   
 
  In December of 2007 the company sold its interest in two limited partnership investments generating a net realized gain. There were no sales of limited partnership interests in 2006 or 2005.
                         
(in thousands)   Years ended December 31,
    2007   2006   2005
Fixed maturities
                       
Gross realized gains
  $ 2,301     $ 4,320     $ 7,231  
Gross realized losses
    (746 )     (3,289 )     (3,234 )
Impairment charges
    (5,101 )     (2,051 )     (2,863 )
 
           
Net realized (losses) gains
    (3,546 )     (1,020 )     1,134  
 
           
 
                       
Equity securities
                       
Gross realized gains
    23,146       13,634       19,517  
Gross realized losses
    (7,912 )     (6,888 )     (3,465 )
Impairment charges
    (17,356 )     (4,391 )     (1,566 )
 
           
Net realized (losses) gains
    (2,122 )     2,355       14,486  
 
           
 
                       
Limited partnerships
                       
Gross realized gains
    538       0       0  
Gross realized losses
    (62 )     0       0  
 
           
Net realized gains
    476       0       0  
 
           
 
                       
Net realized (losses) gains on investments
  $ (5,192 )   $ 1,335     $ 15,620  
 
           

63


 

ERIE INDEMNITY COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
     
Note 5.
  Investments (continued)
 
   
 
 
Change in difference between fair value and cost of investments:
                         
(in thousands)   Years ended December 31,
 
           
    2007   2006   2005
Fixed maturities
  $ (5,759 )   $ (3,213 )   $ (25,342 )
Equity securities
    (13,172 )     10,551       (9,940 )
 
           
      (18,931 )     7,338       (35,282 )
Deferred taxes on unrealized (losses) gains of fixed maturities and equity securities
    6,626       (2,568 )     12,349  
 
           
Change in net unrealized (losses) gains
  $ (12,305 )   $ 4,770     $ (22,933 )
 
           
     
 
 
Our limited partnerships are classified into three primary categories based upon the unique investment characteristic of each: private equity, mezzanine debt and real estate. Nearly all of the underlying investments in our limited partnerships are valued using a source other than quoted prices in active markets. The fair value amounts for our private equity and mezzanine debt partnerships are based on the financial statements of the general partners, who use various methods to estimate fair value including the market approach, income approach and/or the cost approach. The market approach uses prices and other pertinent information from market-generated transactions involving identical or comparable assets or liabilities. Such valuation techniques often use market multiples derived from a set of comparables. The income approach uses valuation techniques to convert future cash flows or earnings to a single discounted present value amount. The measurement is based on the value indicated by current market expectations about those future amounts. The cost approach is derived from the amount that is currently required to replace the service capacity of an asset. If information becomes available that would impair the cost of these partnerships, then the general partner would generally adjust to the net realizable value.
 
   
 
 
For real estate limited partnerships, the general partners record these at fair value based on an independent appraisal or internal valuations of fair value.
 
   
 
 
We perform various procedures in review of the general partners’ valuations, and while we generally rely on the general partners’ financial statements as the best available information to record our share of the partnership unrealized gains and losses resulting from valuation changes, we adjust our financial statements where appropriate. As there is no ready market for these investments, they have the greatest potential for variability. This variability is mitigated through diversification of the portfolio into a varied number of partnerships. Unrealized gains and losses for these investments are reflected in the equity in earnings on limited partnerships in our Consolidated Statements of Operations as is appropriate under equity method accounting. At December 31, 2007 realized equity in earnings from our limited partnerships as reported in the Consolidated Statements of Operations accounted for 12% of our pre-tax income while unrealized equity in earnings from our partnerships, based on valuations provided by the general partners, accounted for 7% of pre-tax income. While we do not exert significant influence over any of these partnerships, it is because we account for them under the equity method of accounting that we are providing summarized financial information in the following table for the years ended December 31, 2007 and 2006. Amounts provided in the table are presented using the latest available financial statements received from the partnerships.

64


 

ERIE INDEMNITY COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
     
Note 5.
  Investments (continued)
                                   
      Recorded by Erie Indemnity Company
      as of December 31, 2007
                      Income (loss)    
                      recognized    
                      due to    
                      valuation   Net
                      adjustments   income
  Investment percentage in partnership    Number of   Asset   by the   (loss)
  for the Erie Insurance Group   partnerships   recorded   partnerships   recorded
                  (dollars in thousands) 
 
 
                               
 
Private equity:
                               
 
Less than 10%
    35     $ 92,077     $ 7,468     $ 12,541  
 
Greater than or equal to 10% but less than 50%
    7       10,708       1,449       1,566  
 
Greater than or equal to 50%
    1       3,831       0       (76 )
   
 
Total private equity
    43       106,616       8,917       14,031  
 
Mezzanine debt:
                               
 
Less than 10%
    13       30,841       109       3,446  
 
Greater than or equal to 10% but less than 50%
    3       10,493       (1,396 )     3,243  
 
Greater than or equal to 50%
    1       3,533       207       926  
   
 
Total mezzanine debt
    17       44,867       (1,080 )     7,615  
 
Real estate:
                               
 
Less than 10%
    19       88,426       8,841       14,246  
 
Greater than or equal to 10% but less than 50%
    9       29,707       3,357       1,293  
 
Greater than or equal to 50%
    7       22,887       2,387       83  
   
 
Total real estate
    35       141,020       14,585       15,622  
   
 
Total limited partnerships
    95     $ 292,503     $ 22,422     $ 37,268  
   
In 2007 we sold our interest in two limited partnerships and completed our commitment in four of our limited partnerships thus reducing our number of partnerships from 101 in 2006 to 95 at December 31, 2007.

65


 

ERIE INDEMNITY COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
     
Note 5.
  Investments (continued)
                                   
      Recorded by Partnerships
      as of December 31, 2007
                      Income (loss)      
                      recognized      
                      due to      
                      valuation      
                      adjustments      
  Investment percentage of partnership    Total   Total   by the   Net income
  for the Erie Insurance Group   assets   liabilities   partnerships   (loss)
      (dollars in thousands)
 
 
                               
 
Private equity:
                               
 
Less than 10%
  $ 24,802,587     $ 558,874     $ 303,611     $ 2,836,059  
 
Greater than or equal to 10% but less than 50%
    416,487       2,232       65,969       3,836  
 
Greater than or equal to 50%
    10,349       25       0       (229 )
   
 
Total private equity
    25,229,423       561,131       369,580       2,839,666  
 
Mezzanine debt:
                               
 
Less than 10%
    4,284,587       366,896       (95,681 )     470,929  
 
Greater than or equal to 10% but less than 50%
    434,269       159,209       (34,872 )     84,384  
 
Greater than or equal to 50%
    204,909       233       3,855       32,947  
   
 
Total mezzanine debt
    4,923,765       526,338       (126,698 )     588,260  
 
Real estate:
                               
 
Less than 10%
    23,626,981       14,153,607       766,150       629,172  
 
Greater than or equal to 10% but less than 50%
    1,106,697       401,752       15,824       49,592  
 
Greater than or equal to 50%
    260,058       140,389       9,234       2,108  
   
 
Total real estate
    24,993,736       14,695,748       791,208       680,872  
   
 
Total limited partnerships
  $ 55,146,924     $ 15,783,217     $ 1,034,090     $ 4,108,798  
   
     
 
  The Company’s investments in the limited partnerships held at December 31, 2007 and 2006 have aggregate assets, liabilities, valuation adjustments and net income (loss) from the most recently available financial statements received from the partnerships, which in most cases are unaudited financial statements as of September 30, 2007.

66


 

ERIE INDEMNITY COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
     
Note 5.
  Investments (continued)
                                   
      Recorded by Erie Indemnity Company
      as of December 31, 2006
                      Income (loss)    
                      recognized    
                      due to    
                      valuation   Net
                      adjustments   income
  Investment percentage in partnership    Number of   Asset   by the   (loss)
  for the Erie Insurance Group   partnerships   recorded   partnerships   recorded
                  (dollars in thousands) 
 
 
                               
 
Private equity:
                               
 
Less than 10%
    38     $ 71,216     $ 8,386     $ 9,237  
 
Greater than or equal to 10% but less than 50%
    6       8,453       (149 )     1,240  
 
Greater than or equal to 50%
    1       2,795       0       (49 )
   
 
Total private equity
    45       82,464       8,237       10,428  
 
Mezzanine debt:
                               
 
Less than 10%
    13       26,250       169       3,988  
 
Greater than or equal to 10% but less than 50%
    3       7,799       505       357  
 
Greater than or equal to 50%
    1       5,722       (76 )     524  
   
 
Total mezzanine debt
    17       39,771       598       4,869  
 
Real estate:
                               
 
Less than 10%
    22       67,840       5,882       9,284  
 
Greater than or equal to 10% but less than 50%
    10       36,590       1,127       1,377  
 
Greater than or equal to 50%
    7       4,281       0       (36 )
   
 
Total real estate
    39       108,711       7,009       10,625  
   
 
Total limited partnerships
    101     $ 230,946     $ 15,844     $ 25,922  
   

67


 

ERIE INDEMNITY COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
     
Note 5.
  Investments (continued)
                                   
      Recorded by Partnerships
      as of December 31, 2006
                      Income (loss)    
                      recognized    
                      due to      
                      valuation    
                      adjustments   Net
  Investment percentage of partnership   Total   Total   by the   income
  for the Erie Insurance Group   assets   liabilities   partnerships   (loss)
      (dollars in thousands)  
 
 
                               
 
Private equity:
                               
 
Less than 10%
  $ 17,976,053     $ 553,372     $ 1,655,077     $ 1,976,202  
 
Greater than or equal to 10% but less than 50%
    351,278       1,425       26,755       7,844  
 
Greater than or equal to 50%
    5,992       25       0       (150 )
   
 
Total private equity
    18,333,323       554,822       1,681,832       1,983,896  
 
Mezzanine debt:
                               
 
Less than 10%
    3,239,894       175,104       49,383       132,642  
 
Greater than or equal to 10% but less than 50%
    336,363       378,345       17,496       14,074  
 
Greater than or equal to 50%
    41,958       18,364       (357 )     2,615  
   
 
Total mezzanine debt
    3,618,215       571,813       66,522       149,331  
 
Real estate:
                               
 
Less than 10%
    16,832,702       6,307,387       299,053       281,569  
 
Greater than or equal to 10% but less than 50%
    1,053,175       400,245       (4,299 )     19,244  
 
Greater than or equal to 50%
    244,242       139,798       0       1,032  
   
 
Total real estate
    18,130,119       6,847,430       294,754       301,845  
   
 
Total limited partnerships
  $ 40,081,657     $ 7,974,065     $ 2,043,108     $ 2,435,072  
   
     
 
  See also Note 19 for investment commitments related to limited partnerships.
 
   
 
  We participate in a program whereby marketable securities from our investment portfolio are lent to independent brokers or dealers based on, among other things, their creditworthiness, in exchange for collateral initially equal to 102% of the value of the securities on loan and is thereafter maintained at a minimum of 100% of the fair value of the securities loaned. The fair value of the securities on loan to each borrower is monitored daily by the third-party custodian and the borrower is required to deliver additional collateral if the fair value of the collateral falls below 100% of the fair value of the securities on loan.
 
   
 
  We had loaned securities included as part of our invested assets with a fair value of $29.4 million and $22.1 million at December 31, 2007 and 2006, respectively. We have incurred no losses on the securities lending program since the program’s inception.

68


 

ERIE INDEMNITY COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
     
Note 5.
  Investments (continued)
 
   
 
 
Cash equivalents are principally comprised of investments in bank money market funds and approximate fair value.
 
   
 
 
Effective February 1, 2008, we have available a $50 million line of credit with a bank, under which there have been no borrowings. Bonds with a value of $62.5 million are held as collateral on the line as of February 1, 2008.
 
   
Note 6.
  Comprehensive income
 
   
 
 
The components of changes to comprehensive income follow for the years ended December 31:
                         
(in thousands)            
    2007   2006   2005
                         
Unrealized (loss) gain on securities:
                       
Gross unrealized holding (losses) gains on investments arising during year
    $(22,772 )     $8,723       $(41,199 )
Reclassification adjustment for gross losses (gains) included in net income
    5,192       (1,335 )     (15,620 )
 
           
Unrealized holding (losses) gains excluding realized losses (gains), gross
    (17,580 )     7,388       (56,819 )
Income tax benefit (expense) related to unrealized (losses) gains
    6,153       (2,584 )     19,886  
 
           
Net unrealized holding (losses) gains on investments arising during year
    (11,427 )     4,804       (36,933 )
Postretirement plans:
                       
Amortization of prior service cost
    342       0       0  
Amortization of actuarial loss
    1,409       0       0  
Net actuarial gain during year
    18,440       0       0  
Losses due to plan changes during year
    (1,334 )     0       0  
Curtailment/settlement gain arising during year
    5,839       0       0  
 
           
Postretirement benefits, gross
    24,696       0       0  
Income tax expense related to postretirement benefits
    (8,643 )     0       0  
 
           
Postretirement plans, net
    16,053       0       0  
 
                       
Minimum pension liability adjustment, net of tax
    0       0       3  
 
           
Change in other comprehensive income, net of tax
    $  4,626       $4,804       $(36,930 )
 
           
     
 
  We adopted FAS 158, “Employers Accounting for Defined Benefit Pension and Other Postretirement Plans,” on December 31, 2006. Net unrecognized actuarial losses and unrecognized prior service costs were recognized as an adjustment to accumulated other comprehensive income at adoption. See also Note 8.
 
   
 
  The components of accumulated other comprehensive income, net of tax, as of December 31 are as follows:
                 
(in thousands)   2007   2006
                 
Accumulated net appreciation of investments
    $15,058       $26,485  
Accumulated net losses associated with post-retirement benefits
    (5,010 )     (21,063 )
 
       
Accumulated other comprehensive income
    $10,048       $  5,422  
 
       

69


 

ERIE INDEMNITY COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
     
Note 7.
  Equity in Erie Family Life Insurance
 
   
 
 
EFL is a Pennsylvania-domiciled life insurance company operating in 10 states and the District of Columbia. We own 21.6% of EFL’s common shares outstanding accounted for using the equity method of accounting. Our share of EFL’s undistributed earnings included in retained earnings as of December 31, 2007 and 2006, totaled $59.1 million and $55.9 million, respectively.
 
   
 
 
The following presents condensed financial information for EFL on a U.S. GAAP basis:
                         
(in thousands)   2007   2006   2005
                         
Revenues
    $147,871       $155,989       $148,876  
Benefits and expenses
    125,091       121,531       124,561  
Income before income taxes
    22,780       34,458       24,315  
Net income
    14,876       21,555       16,539  
Comprehensive income (loss)
    9,128       10,367       (7,242 )
Dividends paid to shareholders
    0       4,158       8,316  
                 
    As of December 31,
(in thousands)   2007   2006
                 
Investments
    $1,511,319       $1,488,846  
Total assets
    1,744,704       1,737,353  
Liabilities
    1,471,317       1,473,094  
Accumulated other comprehensive (loss) income
    (1,465 )     4,283  
Total shareholders’ equity
    273,387       264,259  
     
 
 
Our share of EFL’s unrealized depreciation of investments, net of tax, reflected in EFL’s shareholders’ equity, is $0.3 million at December 31, 2007. Our share of EFL’s unrealized appreciation of investments, net of tax, reflected in EFL’s shareholders’ equity, is $0.9 million at December 31, 2006. EFL’s Board of Directors voted to cease paying dividends effective with the second quarter of 2006 as all shares are now owned by affiliated entities. However, the Board of Directors could decide to declare shareholder dividends in the future. Dividends paid to us totaled $0.9 million and $1.8 million for each of the years ended December 31, 2006 and 2005. See Note 15 regarding the tender offer transaction made by the Erie Insurance Exchange for EFL’s shares during the second quarter of 2006.
 
   
Note 8.
  Postretirement benefits
 
   
 
 
Pension and retiree health benefit plans
 
   
 
 
The liabilities for the plans described in this note are presented in total for all employees of the Group. The gross liability for the pension and retiree health benefit plans is presented in the Consolidated Statements of Financial Position as employee benefit obligations. A portion of annual expenses related to the pension and retiree health benefit plans are allocated to related entities within the Group as incurred. We are reimbursed approximately 51% of the net periodic benefit cost for the pension plans and post retirement health plans by the Exchange and EFL.
 
   
 
 
Our pension plans consist of: 1) a noncontributory defined benefit pension plan covering substantially all employees, 2) an unfunded supplemental retirement plan for certain members of the Erie Insurance Group retirement plan for employees (SERP) for executive and senior management and 3) an unfunded pension plan (discontinued in 1997) for certain outside directors. The pension plans provide benefits to covered individuals satisfying certain age and service

70


 

ERIE INDEMNITY COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
     
Note 8.
  Postretirement benefits (continued)
 
   
 
 
requirements. The defined benefit pension plan and SERP provide benefits through a final average earnings formula and a percent of average monthly compensation formula, respectively. The benefit provided under the pension plan for outside directors equals the annual retainer fee at the date of retirement.
 
   
 
 
We previously provided retiree health benefits in the form of medical and pharmacy health plans for eligible retired employees and eligible dependents. Effective May 1, 2006, the retiree health benefit plan was curtailed by an amendment that restricts eligibility to those who attain age 60 and 15 years of service on or before July 1, 2010. As a result, a one-time curtailment benefit was recognized during 2006.
 
   
 
 
Our affiliated entities are charged an allocated portion of net periodic benefit costs under the benefit plans as incurred. We pay the obligations when due for those benefit plans that are unfunded. Cash settlements of amounts due from affiliated entities are not made until there is a payout under one of these plans. For our funded pension plan, amounts are settled in cash throughout the year for related entities’ share of net periodic benefit costs. Amounts due from affiliates for obligations under unfunded plans are included in reinsurance recoverable from Erie Insurance Exchange on unpaid losses and loss adjustment expenses until such time as payments are made to participants in the plan.
 
   
 
 
On December 31, 2006, we adopted the recognition and disclosure provisions of FAS 158, “Employers Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R).” FAS 158 required us to recognize the funded status of our postretirement plans in the December 31, 2006 Consolidated Statements of Financial Position, with a corresponding adjustment to accumulated other comprehensive income, net of tax. The adjustment to accumulated other comprehensive income at adoption represented the net unrecognized actuarial losses and unrecognized prior service costs, which were previously netted against the plans’ funded status in our Consolidated Statements of Financial Position. Future actuarial gains and losses that are not recognized as net periodic pension cost in the same periods are recognized as a component of other comprehensive income. These amounts are subsequently adjusted as they are recognized pursuant to the recognition and amortization provisions of FAS 87, “Employers’ Accounting for Pensions.”
 
   
 
 
Net actuarial losses and prior service costs, each in the amount of $.3 million, were amortized to other comprehensive income in 2007 for pension and retiree health benefits. Net actuarial gains arising during the year totaled $18.4 million. Curtailment and settlement gains in the SERP of $5.8 million resulted primarily from three retirees being paid in 2007. Losses due to plan changes of $1.3 million were due to five new participants in the SERP effective January 1, 2007.
 
   
 
 
Included in accumulated other comprehensive income for pension and retiree health benefits at December 31, 2007, are unrecognized actuarial losses of $4.6 million and unrecognized prior service costs of $3.1 million that have not yet been recognized in net periodic benefit cost. Prior service costs included in accumulated other comprehensive income expected to be recognized in net periodic pension cost during the fiscal year ended December 31, 2008, are $.3 million.
 
   
 
 
Pension benefit plans
 
   
 
 
The following tables set forth change in benefit obligation, plan assets and funded status of the pension plans as well as the net periodic benefit cost.

71


 

ERIE INDEMNITY COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
     
Note 8.
  Postretirement benefits (continued)
                         
 
    Pension benefits for the years ended December 31,
 
    (in thousands)   2007   2006   2005
Change in benefit obligation
                       
Benefit obligation at beginning of period
    $274,044       $284,977       $241,641  
Service cost
    14,122       16,359       14,564  
Interest cost
    16,765       16,388       14,576  
Amendments
    1,334       0       221  
Actuarial (gain) loss
    (20,319 )     (39,775 )     15,603  
Benefits paid
    (10,175 )     (3,905 )     (1,628 )
 
           
Benefit obligation at end of period
    $275,771       $274,044       $284,977  
 
           
Change in plan assets
                       
Fair value of plan assets at beginning of period
    $254,249       $220,509       $203,071  
Actual return on plan assets
    22,157       27,871       18,996  
Employer contributions
    14,849       8,105        
Benefits paid
    (2,931 )     (2,236 )     (1,558 )
 
           
Fair value of plan assets at end of period
    $288,324       $254,249       $220,509  
 
           
Accumulated benefit obligation, December 31
    $199,604       $185,284       $181,334  
 
           
Amounts recognized in accumulated other comprehensive income, before tax
                       
Net actuarial loss
    $4,355       $28,830        
Prior service cost
    3,316       3,007        
 
           
Net amount recognized
    $7,671       $31,837        
 
           
Assumptions used to determine benefit obligations at period end
                       
Employee pension plan:
                       
Discount rate
    6.62 %     6.25 %     5.75 %
Expected return on plan assets
    8.25       8.25       8.25  
Rate of compensation increase
    4.25 *     4.25 *     4.75 *
SERP:
                       
Discount rate
    6.62       6.25       5.75  
Rate of compensation increase
    6.00       6.00-7.25       6.00-7.25  
Reconciliation of funded status
                       
Funded status
    $12,553       $7,108       $(64,468 )
Unrecognized net actuarial loss
    0       0       82,699  
Unrecognized prior service cost
    0       0       3,463  
 
           
Net amount recognized
    $12,553       $7,108       $21,694  
 
           
Amounts recognized in Consolidated Statements of Financial Position
                       
Pension plan asset (defined benefit plan)
    $32,460       $7,108       $38,720  
Accrued benefit liability
    (19,906 )     (26,903 )     (17,226 )
Intangible asset (SERP)
    0       0       140  
Accumulated other comprehensive income, net of tax
    4,986       20,696       60  
 
           
Net amount recognized
    $17,540       $   901       $21,694  
 
           
Components of net periodic benefit cost
                       
Service cost
    $14,122       $16,359       $14,564  
Interest cost
    16,765       16,388       14,576  
Expected return on plan assets
    (21,028 )     (18,514 )     (17,382 )
Amortization of prior service cost
    493       455       700  
Recognized net actuarial loss
    1,408       4,737       3,595  
Curtailment cost
    532 **     0       0  
Settlement cost
    1,619 **     0       0  
 
           
Net periodic benefit expense before allocation to affiliates
    $13,911       $19,425       $16,053  
 
           
* Rate of compensation increase is age-graded. An equivalent single compensation increase rate of 4.25% in both 2007 and 2006 and 4.75% in 2005 would produce similar results.
**In December 2007, employment agreements for certain members of executive management were signed and incorporated a payment in full of accrued SERP benefits in a lump sum in December 2008, after which time no additional SERP benefits will accrue for them. SERP benefits remain in effect for other senior management. Additionally, the final SERP benefit for our former president and chief executive officer, who resigned in August 2007, will be settled with a lump sum payment in April 2008. These plan changes resulted in a $.5 million curtailment in the 2007 net periodic benefit expense. The settlement cost of $1.6 million in 2007 relates to the annuity purchases and lump sum payouts made to three participants who had retired in 2006.

72


 

ERIE INDEMNITY COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
     
Note 8.
  Postretirement benefits (continued)
                         
    Assumptions used to determine net periodic benefit cost            
    2007   2006   2005
 
                       
Employee pension plan:
                       
Discount rate
    6.25 %     5.75 %     6.00 %
Expected return on plan assets
    8.25       8.25       8.25  
Rate of compensation increase
    4.25 *     4.25 *     4.75 *
SERP:
                       
Discount rate
    6.25       5.75       6.00  
Rate of compensation increase
    6.00-7.25       6.00-7.25       6.00-7.25  
     
 
  The discount rate used to determine net periodic pension benefit cost for 2008 will be 6.62% compared to 6.25% used for 2007. We determined the rate based on a bond-matching study that compared projected pension plan benefit flows to the cash flows from a comparable portfolio of fixed maturity instruments rated AA- or better with a duration similar to plan liabilities. The employee pension plan’s expected long-term rate of return on assets is based on historical long-term returns for the asset classes included in the employee pension plan’s target asset allocation.
 
   
 
  The 2007 actuarial gain was primarily due to a change in the discount rate assumption used to estimate the future benefit obligation from 6.25% in 2006 to 6.62% in 2007. The 2006 actuarial gain was primarily due to a change in the discount rate assumption used to estimate the future benefit obligation from 5.75% in 2005 to 6.25% in 2006, and actual return on plan assets significantly exceeding estimates.

73


 

ERIE INDEMNITY COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
     
Note 8.
  Postretirement benefits (continued)
 
  Pension benefits for the years ended December 31,
 
                           
  (in thousands)   2007     2006     2005  
 
                       
Expected future cash flows
                       
1st Year following the disclosure date
  $ 16,740   * $ 7,951     $ 2,425  
2nd Year following the disclosure date
    4,791       3,973       3,164  
3rd Year following the disclosure date
    5,835       4,893       4,087  
4th Year following the disclosure date
    6,919       6,035       5,039  
5th Year following the disclosure date
    8,315       7,161       6,216  
Years 6 through 10 following disclosure date
    66,867       59,942       53,062  
Pension plan asset allocations (employee pension plan)
                       
Equity securities
    63.3%       64.1%       62.5%  
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