Description

Erie Indemnity is the attorney-in-fact for the Erie Insurance Exchange, a reciprocal insurance exchange (an association of individuals, partnerships and corporations that agree to insure one another). As the management company for the Exchange, Erie Indemnity charges a management fee of up to 25% (currently set at 24%) of direct premiums written. [USAA and Farmers are other examples of reciprocal insurance exchanges that operate with separate management arrangements]. The Exchange is not owned by nor is it consolidated on Indemnity’s financials, which reflect only a 5.5% share in the underwriting results of the Exchange, established through a pooling arrangement.

Erie writes through 8,000 independent agents. It has a very strong corporate culture and is incredibly popular with its agents and policyholders and has won many consumer awards over the years. Call some of their agents (as I have) and hear their thoughts on Erie. You can find a list of agents at www.erieinsurance.com. Most of the agents carry 90% Erie. Their customer retention rate is well above average at 91%. The company targets “ultra-preferred” customers in 11 states (PA, OH, WI, MD, VA, WV, IL, IN, NY, NC, TN) and D.C. 70% of their business is personal lines (auto, homeowners) and 30% is commercial lines.

Read all the details in their filings. Let me get to the value.

The Exchange had $2.1 billion in surplus as of 9/30/02. While the Exchange is technically owned by the policyholders, I would argue that the strong equity position of the Exchange substantially benefits the public shareholders. Float at the exchange (total investable assets less debt less surplus) is approximately $3.1bn. The investment portfolio consists of $2.1bn in equities, $2.2bn in bonds, and $900mm of cash, partnerships and other investments. The portfolio has sustained investment losses of over $2bn in past several years due to decline in equity markets, but is still overcapitalized relative to the business it writes.

Indemnity has about $950mm of capital, $100mm of which is capital needed for its direct insurance subsidiaries. That leaves $850mm of other capital at Indemnity, most of which probably COULD be returned to shareholders (share buybacks, dividends etc.). However, mgmt insists that it will keep the excess capital at Indemnity to serve as “back-stop” capital for the Exchange.

Net premiums written run rate of $3.2 billion means Exchange is writing at 1.5x premiums to surplus (1.1x if you include capital at Indemnity). They could easily write at 2:1 and probably even 3:1. Progressive is currently writing at around 2.7x.

So we have two overcapitalized entities with total book value of approximately $3.1 billion ($2.1bn at exchange and $1bn at Indemnity) and float of $3.1 billion. Current market cap of $2.3bn is 72% of book value PLUS you get $3.1 billion of float. Buying $6.2 billion of investments (pre-tax) for $2.3 billion seems quite attractive. Looking at it another way, if Erie can earn 5% pre-tax, or $202mm after tax on investments, you’re paying 11.4x for an earnings stream growing at 10-15%.

At $36.00, stock is trading at 12x consensus 2003 EPS of $2.95 (and remember that they are overcapitalized).

Erie’s historical combined ratio is a bit over 100 (after adjusting reported combined ratio to add back profit at the management company) so the cost of float is essentially free. Combined ratio over the past two years has been significantly higher primarily due to WTC and technology expense (company has spent a lot of money on extensive new technology platform for its agents). Management is targeting a combined ratio significantly below 100 (93 – 94) for the next decade. While I don’t give them credit for C.R. below 100 in my valuation, any progress on that front will be an added bonus.

Erie has shown impressive growth over the past two years with net premiums written up over 20% for the past several quarters due to a combination of price increases and strong unit growth. Erie grows organically, never through acquisitions.

Erie doesn’t issue stock options and hasn’t issued shares since its IPO in 1925. The reported earnings are truly “high-quality” earnings. I've found management to be conservative and honest.

Risks and other issues

Further decline in investment portfolio at the Exchange. The Exchange is still over-capitalized but would be constrained if they lost another 30 or 40% on their investment portfolio. Of course, you can hedge the risk by shorting S&P or Nasdaq 100. Top positions in the Exchange portfolio include PFE, GE, MSFT, INTC, ORCL, MRK, FRE, and FNM (portfolio is primarily technology, drug and bank stocks.)

The $184mm reserve strengthening recently announced is hopefully a one-time conservative clean-up associated with new CEO. But there is certainly a risk that underwriting results will decline and/or company is not fully on top of its costs.

The founder (H.O. Hirt) set up a trust funded with the company’s voting stock when he died. His two children: Bill Hirt and Susan Hirt Hagen, along with a corporate trustee, each have one vote. The new corporate trustee is currently being selected by Pennsylvania court. The two siblings do not get along and the corporate trustee will decide the vote. This is somewhat complex so I’m just pointing the issue out. Read the filings for all the details.

Catalyst

Secondary offering, which has been weighing on stock, will be completed tonight. One of the agents and largest stockholders is selling 3mm shares to pay estate taxes. Stock may pick up after offering successfully completed.

Fourth quarter results will be muddied by various charges which I don’t believe will recur, while 2003 results should be solid given strong insurance markets and Erie’s growth.

Long term growth in premiums (and therefore float) and better investment returns will steadily add value to entity.