Erie Indemnity Co (ERIE) 2003 Q2 法說會逐字稿

Hello, and welcome to the Erie Indemnity Company's Second Quarter Earnings Conference. At the request of Erie Indemnity, this conference is being recorded for instant replay purposes. At this time, all participants are in a listen-only mode. Following prepared remarks from management, we will open the call for questions and answers. Now, I'd like to introduce your host for today's call, Ms. Karen Kraus Phillips, Vice President and Manager of Corporate Communications and Investor Relations. Please go ahead.

Thank you, Jessica, and good morning. We appreciate all of you joining us today. On today's call, management will discuss our second quarter 2003 results. Joining me are Jeff Ludrof, President and CEO, Executive Vice President and Chief Financial Officer Phil Garcia, and [Brian Bolash][ph], Associate Counsel.

Today's prepared remarks will be approximately 30 minutes. Following those remarks, we will open the call for questions. We'd ask that you please keep to one question and a follow-up.

We issued our earnings release and additional supplements yesterday afternoon. If you need a copy of the press release or any of the exhibits, you can find these in the Investors section of our website at ErieInsurance.com. We also filed Form 10-Q with the SEC.

On today's call, Management of Erie Indemnity Company will share important information about current and future initiatives being undertaken at the Company. As a result, certain forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995, may be incorporated into their comments. These forward-looking statements reflect the Company's current views about future events and are based on assumptions subject to known and unknown risks and uncertainties. These risks and uncertainties may cause results to differ materially from those anticipated as described in those statements. Many of the factors that will determine future events or achievements are beyond our ability to control or predict. For information on important factors that may cause such differences, please see the Safe Harbor statements in our latest 10-Q filing with the SEC dated July 24, 2003 and in the related press release and 8-K.

This call is being recorded, and the recording is the property of Erie Indemnity Company. It is not intended for reproduction or rebroadcast by any other party without the prior consent of Erie Indemnity Company. A replay will be available on our website today after 12:30 PM Eastern Time. Your participation on this call will constitute consent to the recording, publication, webcast, broadcast, and use of your name, voice, and comments by Erie Indemnity. If you do not agree with these terms, please disconnect. Thank you.

I'd now like to turn the call over to Erie's President and CEO, Jeff Ludrof.

Thank you, Karen, and thanks to all of you for taking your time to be on the call with us today.

This morning, I'll talk about our Company's performance during the second quarter, the key drivers that impacted our performance, and specifically our continued emphasis on underwriting profitability. I'll also elaborate on the announcements we made in yesterday's press release regarding Minnesota, agent appointments, and our assumed reinsurance business. Phil will then review the Company's second quarter financial results.

We continued to see significant premium growth during the second quarter, with direct written premiums increasing by 17.9 percent to $973.9m. This was due primarily to rate increases and our continued strong retention ratio of 91 percent for the second quarter. Our new business growth has slowed in 2003 from the robust growth we experienced in 2002.

Some of our underwriting profitability strategies have also stimulated premium growth. Through our agents' efforts to actively reunderwrite their book of business, they are reassigning more appropriate valuations on homes and commercial properties and applying more precise vehicle usage classifications for private passenger automobile coverages. Of course, we are also being more vigorous in non-renewing consistently unprofitable business, which will have the effect of lowering our policy retention rates.

As a results of our premium growth, management fee revenue increased by 12.7 percent for the quarter. While substantial, the rate of growth is slower when compared to the same quarter in 2002 as a result of the reduction in management fee rate from 25 percent in 2002 to 24 percent in 2003. Our cost of management operations increased by 15.3 percent, with agent commissions increasing by 17.8 percent in correlation with the increase in direct written premium. The resulting net income for the quarter increased by 13.9 percent to 77 cents per share, compared to 67 cents per share a year earlier. In both the 10-Q and press release, we announced some additional actions we are taking to support our focus on underwriting and underwriting profitability, our number-one goal in 2003.

On the year-end and first quarter call, we talked about our objective to bring the combined ratio in line with historical results. We're refining our priorities to accelerate our underwriting profitability initiatives. As part of this effort, we identified several actions that we're taking in support of the Company's underwriting profitability goals: relaxing the timeframe for Erie's entry into Minnesota, suspending new agent appointments as of August 15, 2003 through the remainder of the year, and exiting the group's assumed reinsurance business. These actions allow us to redeploy resources to support Erie's underwriting profitability strategies.

You heard me say before that our success is predicated on steady, long-term growth in indemnity earnings. These actions we're taking will strengthen our focus on underwriting profitability, stabilize our quality growth, and ensure that the exchange remains strong well into the future.

Over the last several years, Erie's growth rates have exceeded historical levels. By appointing new agents and stimulating same-store sales, we have increased our policies in force by nearly 40 percent in just four years. During that period of time, we've also continued to expand geographically, adding our fourth region, the Heartland region. Erie has had great success in developing the Heartland region. Both Illinois and Wisconsin have surpassed record growth rates for new states. Today, just four-and-a-half years after entering Illinois and less than two years after entering Wisconsin, we now have 177 new agencies in these territories.

In December 2001, we announced our plans to expand the Heartland region by entering Minnesota. Originally, our plans called for us to begin writing business in Minnesota by late 2004. Given the strong growth we've experienced and our need to concentrate efforts on underwriting profitability, we have decided to relax our timeframe for entry. We will continue our efforts to obtain a license in Minnesota in anticipation of our entry at a future date. We will continue to evaluate our timeframe for entry into the state with consideration to our progress on improving underwriting profitability.

The same rationale holds true for our decision to suspend agent appointments for the remainder of 2003. In just five years, we've appointed more than a third of our agency force. These new agencies have contributed immensely to our growth in policies in force and written premium. During that period, our long-term agents increased their marketing efforts, leading to strong sales growth. We made the decision to suspend agent appointments in order to achieve growth rates consistent with our steady-as-you-grow philosophy and reinforce Erie's underwriting fundamentals. This allows our field managers to focus attention on training new agents, supporting all agents' reunderwriting efforts, and helping them to effectively apply Erie's underwriting guidelines. Appointments in 2003 should total about 55 new agents versus our original estimate of 136. To date, our emphasis on underwriting profitability through the AWARE program, agents' writing and reunderwriting excellence, and other initiatives are producing favorable results.

The second quarter 2003 reported combined ratio for Erie's property and casualty group is 105.7 percent, a marked improvement from the 113.2 percent for the first quarter 2003.

The spike in private passenger automobile frequency we commented on in the first quarter results moderated in the second quarter. Year-over-year frequency at June 30, 2003 declined 1.7 percent for this line. This contributed to a private passenger auto combined ratio of 105 percent for the second quarter 2003, compared to a 118.4 percent in the first quarter. Homeowners' combined ratio has also improved from 109.8 percent in the first quarter to 105.3 percent in the second quarter of 2003. Accelerating our efforts by concentrating more fully on underwriting issues can only improve our results.

Now, to our decision to exit the assumed reinsurance business. We entered the assumed reinsurance business in 1990 after Pennsylvania passed Act 6, which required rate rollbacks on personal auto in the state. Our strategy was to gain more spread of risk and, thereby, lessen our business concentration in Pennsylvania. Throughout most of the 1990s, Erie's assumed reinsurance business produced solid financial results for the group. During that same period, Erie increased the spread of risk of its direct business through our entry into North Carolina, New York, Illinois, and in 2001, Wisconsin. We are not as heavily concentrated in personal lines today as we were in the 1990s. At that time, personal lines made up over 80 percent of our business. Today, our business spread is about 70 percent personal lines and 30 percent commercial.

We also began to experience more frequent natural catastrophes, both domestically and internationally, which increased our loss exposure in the reinsurance line.

These factors, combined with the 9/11 tragedy and the current dynamics in the reinsurance marketplace caused us to rethink our strategy regarding reinsurance. We have concluded that the volatility of the reinsurance market outweighs the benefits of continuing our assumed reinsurance business. While we will fulfill our current treaties, it is in the best interest of the Company to pull back and focus more fully on our core competencies.

We are currently examining our strategic options around this position of this business. There are 18 people who work in our assumed reinsurance operations. The projected annual premium volume for 2003 associated with this business is approximately $130-140m. These employees will be redeployed on critical underwriting profitability initiatives. They are among Erie's best and brightest, and their unique set of skills and perspective will be an added boost in achieving our underwriting profitability goals. Erie has always been, first and foremost, a strong underwriter. We take a long-term view in managing our property and casualty business. Throughout our history, that focus has benefited both the policyholders of the exchange and the shareholders of Erie Indemnity.

I'd also like to address a question that came up on the first quarter call regarding capital usage, specifically, share repurchase. As we told you, we would be discussing the topic of share repurchase with our Board at the June Board meeting. In our discussions, we looked at the broader topic of capital utilization in light of the new environment regarding dividends. While no specific decisions were made at that time regarding share repurchase, we continue to talk with our Board about the best options for using our capital.

Regarding the Board, I couldn't be more pleased with the results of the shareholder election. Our new Board members are truly engaged and are quickly getting up to speed on the organization, the strategic issues facing the Company, and our unique corporate culture. The entire Board is working together and is focused on achieving the Company's goals.

Now, I'd like to turn the call over to Phil, who will review our second quarter financial results.

Thanks, Jeff, and good morning, everybody.

As expected, many of the same factors affecting our results in the first quarter of 2003 continued to impact our second quarter 2003 results. For the second quarter 2003, net income increased 13.9 percent to $54.5m, or 77 cents per share, compared to $47.8m for the second quarter of 2002.

Net income, excluding the effects of realized capital gains and income taxes on those gains, rose 1.3 percent for the quarter to $52.3m, up from $51.6m for the same quarter in 2002, or 74 cents per share versus 73 cents per share for the second quarter of 2002, an increase of 1.5 percent.

As I review the management operations, you can refer to the exhibit, Consolidated Statements of Operations, the Segment Basis, which was included in the supplemental data issued with the press release.

First, I'd like to discuss our performance in our Management Operations segment. Management fee revenue grew by 12.7 percent to $232.7m for the second quarter, compared to $206.6m in the second quarter of 2002. Management fee revenue continued to grow at a slower rate in the second quarter 2003 than the increase in premiums written due to the action of our Board of Directors to reduce the fee rate from 25 percent to 24 percent.

Direct written premium in the second quarter grew by 17.9 percent, totaling $973.9m, compared to $826.3m a year earlier. This growth rate was driven primarily by year-over-year policy-in-force growth of 11 percent and a 10-percent year-over-year increase in average premium per policy. The 11-percent increase in policies resulted primarily from our continued high retention ratio of 91 percent at June 30, 2003.

Jeff talked about the Property and Casualty Groups' combined ratio of 105.7 for the second quarter of 2003, which we attributed to our concentration on underwriting profitability. That same emphasis on underwriting profitability has had a measured effect on the number of new policies. As expected, we continue to see premium growth moderate from new policies written. As a result of these factors, written premium on new policies decreased by 6.5 percent overall, with personal lines decreasing by 4.3 percent and commercial lines decreasing by 10 percent for the three months ended June 30, 2003 versus the same period of the prior year.

Service agreement revenue decreased for the quarter by 11.7 percent to $6.9m, from $7.8m during the second quarter of 2002. This is due to lower service agreement revenues on voluntary reinsurance premiums and flat service charge revenue. The reduction in service fee income on voluntary assumed reinsurance premiums written by the exchange was down 36.7 percent to $1.9m in the second quarter 2003 from $3m in the second quarter of 2002. The decrease resulted from the continued effect of the exchange non-renewing unprofitable [treaties][ph] and the resulting reduction in service agreement income, as well as the reduction in the service fee rate from 7 percent in 2002 to 6 percent in 2003. Voluntary assumed reinsurance premiums decreased 24.3 percent to $32.2m in the second quarter of 2003 from $42.5m in the second quarter of 2002.

Also included in the service agreement revenue are service charges the Company collects from policyholders for providing extended payment plans on policies written by the Property and Casualty Group. The service charge revenue for the second quarter of 2003 was $5m, compared to $4.8m for the quarter ended June 30, 2002.

The cost of management operations increased by 15.3 percent in the second quarter to $170.1m, from $147.5m for the same period in 2002. Commissions paid to our independent agency force account for the majority of these costs. Commission costs totaled $125.3m for the second quarter of 2003, a 17.8-percent increase over the $106.4m for the second quarter of 2002.

Other operating expenses, excluding commissions, increased by 9 percent to $44.8m, compared to $41.1m a year earlier. Personnel costs, including salaries and wages, employee benefits, and payroll taxes, which encompassed the largest component of Other Operating Expenses increased 8.6 percent to $26m for the second quarter of 2003, compared to $24m for the same period in 2002.

The Company will continue to experience increased costs for its share of the employee pension plan as a result of lower plan asset returns and discount interest rate assumptions. In the second quarter of 2003, pension plan costs increased about $600,000. We can expect about the same impact per quarter through the end of 2003.

The gross margin for management operations was 29 percent for the second quarter. If the management fee and the service fees were at the same rates as last year, the gross margins would've been 31.9 percent at the end of the second quarter, compared to 31.2 percent in the second quarter of 2002.

Next, I'd like to discuss our insurance underwriting segment. As you know, the Erie Indemnity Company's property and casualty insurance subsidiaries, Erie Insurance Company and Erie Insurance Company of New York, retain a 5.5-percent share of the underwriting results of the property and casualty group. The group's reported statutory combined ratio for the second quarter of 2003 was 105.7. Erie Indemnity Company's reported GAAP combined ratio for the second quarter was 113.3 due to the effect of the reinsurance agreement with the exchange.

In the second quarter of 2003, a $1.8m recoverable recorded under the agreement in the first quarter was reversed due to the improved underwriting result of the property and casualty group in the second quarter of 2003. In total, Erie Indemnity recorded underwriting losses of $6.3m in the second quarter of 2003, compared to $6m for the second quarter of 2002.

Our investment operations during the second quarter recorded income of $17.9m, compared to $10.8m for the same period in 2002. Net investment income was flat for the quarter, increasing by .6 percent to $14.2m, from $14.1m for the second quarter of 2002. This was due primarily to lower investment yields on our fixed maturity portfolio. Lower yields were offset by increased operating cash flows, which were invested in fixed maturities. The Company realized net gains on investments of $3.4m, compared to net realized losses of $5.8m a year earlier. Net realized losses in the second quarter 2002 were affected by impairment charges of $10.7m related to fixed maturities and non-redeemable preferred stock investments. There were no impairment charges in the second quarter of 2003.

The Company also recorded equity [in] losses from limited partnerships in the second quarter 2003 of $1.4m, compared to earnings of $2.2m in the second quarter 2002. This was due primarily to losses in private equity of $1.9m and income from fixed income and real estate limited partnerships of $0.5m for the second quarter of 2003.

The Company's earnings from its 21.6-percent equity ownership of Erie Family Life Insurance Company increased to $1.7m in the second quarter of 2003 from $0.2m for the second quarter of 2002. This was due primarily to strong increases in net investment income, realized capital gains, policy revenue, and decreases in net death benefits. We issued a separate press release yesterday summarizing the results for Erie Family Life's second quarter.

Now, I'd like to turn the call back over to Karen.

Thank you, Phil. That concludes our prepared remarks. Jessica, if you could now open the call for questions from our phone audience.

Thank you. [Caller instructions.]

And we'll take our first question from [Adam Klowler][ph] with Cochran, Caronia. Please go ahead.

Good morning, Phil and Jeff.

Good morning, Adam.

Good morning.

Could you give us some idea of where you think the premium growth will go toward the end of this year and going into 2004?

Well, Adam, you can see during the quarter our year-over-year growth rate dropped from 12.4 to 11. So that was a 1.4 percentage point drop. During the second half of last year, we had very strong new policy growth rates. As you know, we had an incentive contest for our agents, so we had very strong growth last year. And we've already told you that our new policy growth this year has moderated, so we think our year-over-year number, units, unit growth, year over year by year-end will be in the high single digits.

Okay, thank you. Also, Phil, have you noticed a more competitive environment for auto and homeowner business? Has the environment become more competitive in the last three months?

Adam, this is Jeff. I think the environment in the last three months has continued what it's been. I think it's a very competitive environment out there -- many players looking to write business, some companies taking more drastic actions than other companies in their appetite for risk. I would describe it in the past quarter much different than the prior first quarter of the year.

Thank you.

Our next question comes from [Ira Malice][ph] with Legg Mason. Please go ahead.

Great. Thanks. I've got a couple just quantitative questions. Phil, when you described the $130-140m of premiums that were projected to be written for the reinsurance, the fee that you earn on that, is that the 6-7 -- is that the 6 percent that -- was that the fee that you would earn on that business?

That is the fee that Erie Indemnity would earn on that business, yes.

Okay, so that's how you get to the kind of 9 cents is applying a 6-percent number to the 130 or 140 --

Right --

-- and tax-effecting and all that kind of stuff?

And as we told you, Ira, we have 20 people -- 18 people --

Sure.

-- in that group, and we're going to redeploy them, so they're going to -- the expenses associated with that revenue aren't going to go away.

Okay.

-- for the most part. So you just 6 percent of that volume --

Right.

-- and take [inaudible].

Yeah, okay. Secondly, on the investment side, if I went back to your 10 to your statutory statement and got your list of your holdings, has there been much change in the common stock holdings since the first of the year? Or it's another way of asking, have you deployed outside investment managers to -- has the portfolio changed? I mean answering it as broadly as you'd like.

You're referring to the portfolio of the exchange?

I am, yes, that's correct.

Yes, the portfolio of the exchange has changed. If you look at the Q where we disclosed the select financial data of the exchange --

Right.

-- you'll see that the common portfolio of the exchange has declined from $2.2b to $1.95b from December to June. And we provide some further disclosure. During the second quarter, we have sold almost -- well, I'll read it exactly for you. We've generated proceeds from the sale of the common-stock investments of the exchange of almost $600m, which included $102.4m in realized gains. We initiated in the second quarter a planned reallocation of invested assets with the intent of lessening our exposure to common stock investments. We are continuing that. Part of that is related to the transition to new managers, but, clearly, we want to lower -- lessen our exposure to common stocks prior to moving to new managers.

Okay. I just want to follow up with one more. I'm having trouble putting all the pieces together, and maybe there's just something I’m missing, and that's fine. Your surplus has gone up in the -- I’m not going to ask about use of capital, okay? This is totally different.

Okay.

Surplus is going up. So you've got more surplus and you're getting out of the business that probably requires the most surplus. I would imagine the reinsurance soon would be the least predictable business, which I’m assuming would require, you know, more capital to support it. You've told us your underwriting results are improving, so we now have more surplus, less demand in the surplus. You've made it clear that you haven't taken any steps to -- well, I mean it's a totally different [inaudible]. You know, what's happened -- I'm sorry, I'm rambling a bit. Why pull back on the growth initiatives if (a) you've got more surplus, (b) you've got less strain in that surplus, and (c) we're starting to see improvement on the underwriting side?

Well, I'll answer it, and I'll let Jeff follow up.

Sure.

You know, we did have a great quarter in the common stock markets here in the second quarter, and it did allow our surplus -- well, from December 31 to June 30, our surplus at the exchange increased $175m. So we're very pleased the fact the common stock markets performed as well as they did. But we want to lower our investment leverage, and we're going to do that; we've told you already. You just asked the question about lowering the common stock portfolio, and you did indicate -- as you did indicate, we want to lower our insurance leverage, and we're doing that through exiting the reinsurance business and slowing our growth a little somewhat. We think all those things are good to do, and we want to return to underwriting profitability that's been our historic underwriting profitability. I mean we did have a 105.7 for the quarter and showed great improvement over the first quarter, but we think we have more work to do on that. As you know, combined ratios are coming down all across the industry in personal lines companies.

Sure.

So we want to continue that momentum, and we want to improve it more.

Okay, I have one more quick follow-up and then I'll get off. Were any of these actions that you've announced the result of kind of what you need to do to keep an A-plus rating? And if the answer to that is yes, is there anything else that you have to do to keep that rating?

Well, let me take that, Adam -- or let me take that --

Ira.

-- Ira, I’m sorry.

Sure.

Let me say that these are the right things to do. This is the right thing to do for a company that focuses on underwriting and solid and consistent and long-term focus on consistent earnings, consistency in the way we approach the marketplace with our policyholders, our agents, our shareholders. Returning to an A-double-plus rating is important to us. I would not say those actions designed entirely or even primarily to return to an A-double-plus rating, but I believe these actions will benefit us by our focus and our balance on underwriting profitability, steady and consistent earnings, and an additional benefit of achieving that goal to regain our A-double-plus rating.

Great. Thank you very much.

We'll now go to [Matthew Roswell][ph], also with Legg Mason. Go ahead, please.

Yes, I guess we're double-teaming it. Just one follow-up, Ira. Looking at the combined ratios, you've said sort of getting back to more normal historical levels. Do you have a particular sort of target in mind? And what sort of timeframe are you thinking of?

Well, our target has always been at the combined group level to have a statutory combined of 100.

Okay.

And as we've told you, that's a reported statutory combined, and, you know, to put us on an apples-to-apples basis with other insurance groups, you really have to consider and adjust that for the excess management fee that is paid to Erie Indemnity Company. So, you know, on an apples-to-apples basis, with a 24-percent management fee, that's about a 94. But it's always been our goal at the group level to have 100 reported [inaudible].

Okay. And so what of timing? Is this going to be a slow and steady progress? Is that the idea?

Well, we want to make progress on improving our underwriting ability. We're doing it in a manner -- a consistent manner to improve it steadily. Will we get from -- right now where we're at now to 100 in the next six months? I don't think so.

Okay. Thank you very much.

We have a question from [Beth Malone][ph] with Advest. Go ahead, please.

Okay, thank you. Just a couple questions. One, on the growth rate of management fees and growth rate in the premium for 2004, I understand that we're losing some revenue from the reinsurance business. But do you anticipate an acceleration of growth due to this pricing environment that we're in should offset some of that in terms of the total management revenues?

Yeah, Beth, we put in our Q what we believe our increases we've either filed or plan to file or filed and waiting approval. We've detailed those in the queue. You'll see it adds up to about $228m, which is very consistent with the -- about the average we are filing for this year. It's in about the 6-6.5-percent range, so we believe we're going to get price movement equivalent to this year next year. Then, of course, on top of that, you have to add what we call symbol creep in the industry, which is a percent-and-a-half to [inaudible] and other actions we're taking to get the proper premium for the risks that Jeff mentioned in both the auto line and the homeowners' line will help. And then I've already talked about unit growth, where we think the unit growth is going. So you add all those together, and you can guesstimate of where our growth will be next year. So you've got about 6, 6.5 in rate, a point-and-a-half to 2 in symbol creep, a little -- you can calculate a little effect for this -- getting the right premium for the right risk, and then unit growth in the high single digits. I think that's where we are right about today. That's our thinking today on the growth for 2004.

Okay. Also, going forward, do you anticipate any changes to the profit margin on the management operations? Is that anticipated to change at all with any of these actions?

You're talking about the management fee?

Right. The cost of the -- the expenses related to the management fee. Do they stay fairly -- does that margin stay fairly solid even [with] all these actions?

Yes, it should. That doesn't preclude other actions we might take going forward to improve our underwriting results. As you know, Erie Indemnity Company is responsible for underwriting expenses, so it's possible that we spend some money at Erie Indemnity Company, who has responsibility for these underwriting costs, to improve our underwriting profitability margin, but certainly if we do those things, we'll tell you about them; we'll talk to you about them.

And, Beth, this is Jeff. I would just add that to build on Phil's point that we believe on spending wisely to invest dollars in expenses that can produce an underwriting profitability improvement that will exceed that expense investment two-, three-, four-fold, so we're looking at a number of initiatives where spending money could produce a savings, both potentially in the short term but definitely in the long term.

Okay, just two more questions. On the restructuring of the balance sheet, do you anticipate that having any material effect on the overall yield on the portfolio since you're moving from non-, I assume, non-income-producing to income-producing assets?

Yes. We are moving -- as I said, we want to lower our exposure to common stocks, reduce our investment risk, so we are selling some -- a good amount of stocks and redeploying that into fixed maturities, so, of course, interest rates are pretty low right now, but we're staying pretty short on the investments we're making in fixed maturities, so -- but it will definitely help the investment income stream.

Do you have a goal in mind of where you want the mix to be by year-end? Are we going to see more sales of common equity throughout the year?

We do have a goal. Our common equities at one point were in excess of 100 percent of the surplus of the exchange, and our goal is -- our interim goal, at least, is to get the common equities down to about 60 percent of our surplus.

Okay. Final question on the life insurance company. Are there any plans to buy the rest of that in given that it's performing so well or spin it off or something?

We have no plans at this point to do that.

Okay, thank you.

Thank you, Beth.

We'll take our next question from [David Shussey][ph] with J.P. Morgan. Please go ahead.

Yeah, hi. Good morning, everyone.

Hi, David.

Hi, David.

Good morning.

Good morning. Just a couple follow-ups on the reinsurance side. I'm a little bit unclear on the timing. Are you thinking about that in terms of a run-off? Or are you actively out, you know, trying to sell that business?

We're not going to write or renew any assumed reinsurance premiums past December 31.

Okay.

All right, so there will be -- in terms of Erie Indemnity Company, there will not be a service fee revenue stream from this business starting 1/01.

And I guess -- how do we think about the underlying capital? You know, our Legg Mason friends were talking about the capital allocated to that business, you know, likely anywhere from 150 to $200m of underlying capacity or surplus. What's your thought on that side of it?

Well --

Oh, excuse me. Is that going to be a part of your balance sheet? Or does that go away or--? How does that work?

Well, what it does is does is it deleverages our insurance risk with respect to our direct business. You're right that a lot of capital is used in the reinsurance business; a lot of capital is supporting our homeowners' business as well. But in effect what we're doing with this action is deleveraging our investment risk. We are taking $140m of premium out of the numerator, and the denominator's not changing in terms of premium to surplus ratio. So that's the effect.

Okay. And just on the margin side with the underwriting profitability with the commercial lines business, we got the personal auto and the homeowners. Where did we fall out on the other side?

You know, we haven't seen as much improvement in our loss ratios on the commercial side. We certainly didn't see it in the second quarter. They're still unacceptable in our estimation, and we need to improve upon those. So we're going to have some underwriting initiatives that focus on commercial lines.

Okay. And are you providing those numbers?

I can -- as soon as I can find them.

Hey, Phil and Jeff, it's Hugh as well.

Hi, Hugh. How are you?

Hi, Hugh.

Good.

Yeah, our -- you know, our second quarter, worker's comp combined ratio was 122, which is, you know, not very good at all. And our commercial package policy combined ratio was very high, also, in the -- well, yeah, that was in the 120s, also. So we have a lot of work to do on the commercial side to improve our underwriting results in those lines.

Okay, great.

Phil, I just have one quick question. Can you give us -- it's more pedestrian, I guess -- can you just give us an update kind of on the Pennsylvania auto market right now, what you're seeing from a competitive landscape?

We filed a rate increase effective 1/1/04 for Pennsylvania auto of slightly more than 7 percent. It will generate about $65m in premium in 2004 for the Company. Of course, when we file for that, it reflects our need on that line of business, and it also reflects the competitive environment, our competitive placement relative to our major competitors in Pennsylvania, which are State Farm, Allstate, Nationwide. So, you know, we think that that rate increase will still keep us effective in the marketplace in terms of our competitiveness and will help our efforts to improve underwriting profitability.

We've seen some slowdown on a national basis, but it doesn't sound like you're seeing a whole lot of it in Pennsylvania from a rate standpoint.

Well, I know that that rate increase still positions us competitively --

Okay.

-- in Pennsylvania market against our major competitors.

You used to give us numbers in the past, and you probably don't have it now. It's not that important. But where you would say for the number of counties where you thought you were, you know, still very competitive. Would that put you more -- with that rate increase, it would still put you more competitive in the majority of the counties?

Hugh, this is Jeff. I think it keeps us in a relative, consistent, competitive position.

Okay.

There are 67 counties in Pennsylvania. We have, in fact, commented in the past that for various single rating scenarios --

Sure.

-- you might find us the number-one price competitive -- even though we sell everything that we have to offer, not just the price -- in, let's say, 63, 64, 65 out of the 67 counties having the lowest price for a particular example. We maintain a very strong competitive position. This rate change will really keep us in that same strong competitive position, so we're very comfortable. It will enable us to continue to see growth and retention of our quality auto business in Pennsylvania.

Great. I appreciate it.

Thank you.

Our next question comes from [James Penn][ph] with [CP&E Partners][ph]. Please go ahead.

Hi, guys. Just a couple questions. Your policies went up 9 percent in terms of number of policies out there, and your compensation or your overhead, excluding the commission, also went up 9 percent. Shouldn't we be seeing better leverage in terms of our infrastructure? Shouldn't expenses be going up slightly less than the number of policies?

Well, James, our unit growth year over year is 11 percent actually. Now, that's a lagging indicator because it's obviously a 12-month rolling number.

Okay.

So what we measure is our unit growth against our full-time equivalent because our biggest expense is employee expense, --

Okay.

-- the benefits that are derived off of that.

Right.

Our employee growth is in the 8-percent range year over year, full-time equivalence. So, you know, our number of policies per employee has actually gone up. We use that as a productivity measure that we track, so we have 3-percent productivity improvement year over year in the indemnity company's operation. So as long -- we monitor that very closely, and now our unit growth is coming down. So the challenge for us is to make sure that our employee growth stays beneath that, and so we have improved productivity here. So we do monitor it. We have had, I think, very strong productivity growth as measured by number of policies per full-time equivalent employee. And, James, I don't know if you noticed in the Q, we did provide you the --

Yeah, I appreciate that. Actually --

-- forward-looking P/E on the exchanges for common stock portfolio.

I appreciate that. I was going to note that with you offline. I was -- I didn't want to bring it up now, but I was hoping that instead of trailing P/E, that you could forward P/E there because, you know, I really don't care what happened last year; I want to know what these companies are going to earn this year and two years from now.

All right. We'll take that under advisement, James.

And the other question. When we consolidate the management company results back into the statutory results for the exchange --

Yes?

What's your combined ratio when you do that exercise?

Well, what you're going to do is you're going to take the 105.7 --

Yeah.

-- and you've got to GAAP it, which means you've got to take the underwriting expenses as a percentage of earned premium instead of written, so it's going to go up slightly because, obviously, the earned number is smaller. So I think it goes up about a point.

Okay.

And then you have to take the effect of this reinsurance agreement between the exchange and indemnity company, which we explained in the Q and in the press release, that there's this $1.8m adjustment between the companies on that agreement.

Right.

And that produces the 113 -- 113.2, I believe it was --

Okay.

-- for your indemnity. So you've got to GAAP the number and then take the effect of this agreement between the companies, which obviously isn't pooled.

But if we're looking for a consolidated statutory accounting basis combined ratio -- forget about GAAP -- how would we do that? I mean why don't we just take the operating profit from the holding company, put it back into the underwriting loss. Say underwriting loss is only, what, 10 million, and then also adjust the 5-percent underwriting share in agreement. In other words, bring back the --

Yeah, you could -- what you could do is take the 113.2 that Erie Indemnity Company recorded, strip out the $1.8m. That gives you a GAAP-combined ratio for the group.

Okay.

And then, you know, that should get you close to the 105.7, and the difference will be the effect of GAAPing it.

Okay.

If you want to call me --

Yeah, I'll call you after.

-- I can take you through the calculation.

All right. I appreciate it.

Yeah.

We have a question from [Charles Gates][ph] with Credit Suisse First Boston. Please go ahead.

I thought my phone wasn't working because I've tried several times. Hey --

Well, you got through, Charlie.

Yeah, perseverance conquers all. Hey, that was my track coach in high school who said that. First question. Who is the new manager of the invested assets?

We're currently -- it's not going to be just one firm; it's going to be a number of firms. We haven't yet decided, but we're working very diligently to get to who that is -- who they are here by year-end.

Okay. Who is the current manager of the invested assets?

[John Peterson][ph] continues to manage it and will continue to manage it through the transition until the hand-off is complete.

How old is Mr. Peterson?

John's 75?

Okay.

Seventy-four.

Seventy-four.

Okay. Second question. Well, first a comment. The comment is that I think your surplus rose $2.5m a day in the second quarter, and that's pretty good. And I guess that, in part, reflected the fact that at least at some point in the recent past you had five million shares of Intel.

Yeah?

Okay.

We appreciate your calculating that number for us!

Okay. What is the import of an A-plus-plus Best rating for the exchange? And the derivation of that question is, in part, the fact that I believe Progressive used to have this A-plus-plus Best rating up until about three years ago, and then they say, "Hell, the A-plus is fine."

Charlie, I would say that an A-double-plus versus an A-plus is an important distinction, and yet enables us at an A-plus to remain in a very relative position known for financial strength in the marketplace. The A. M. Best organization has as their highest rating category a category called Superior, within which there are two ratings -- I think you know that -- A-double-plus and A-plus. We have the lower of the two but remain in the highest category.

Equally as important is the fact that when A.M. Best assigned us a lower A-plus rating in their highest category, they also assigned us a rating outlook of Stable. And that signifies their strong view of the Erie as a stable organization -- financially stable -- at their highest rating category. That has enabled our agency force and our policyholder base to remain confident in the Erie's financial strength and has not affected our ability in any material way to continue to attract and retain the most desirable and quality customers out there in the market.

Okay. My third question, Jeff, I thought an answer to one of the questions earlier, you opined -- you thought that the personal lines' pricing environment was becoming possibly more competitive. In that regard, if you look at the CPI data and I guess it'd show rate increases on the order of like 8.8 percent, would you elaborate on the gist of that comment, sir?

Well, in terms of it becoming more competitive, I would say that companies have taken, in some cases, drastic actions. What that does, in my view, is leave the better companies to compete more strongly for the very best business. It's competitive in the sense that we have directed the focus of attention of our agents to writing what we term the most desirable business, and there is a competitive effort in the marketplace through many different methods and tools to, of course, write the most desirable business. We are a preferred risk insurer, and so we compete in a narrower marketplace that others, too, would prefer, and, therefore, it becomes more competitive as there is pressure of all companies to improve their underwriting result.

My final question, sir. Why do you guys write commercial lines insurance?

Well, we write commercial lines insurance because it gives us a spread of risk because I believe we possess the core competencies to successfully write commercial insurance. It allows us to further our relationship and build the loyalty of a consistent revenue stream through our independent agency force by offering them a full loaf, if you will, of products, both in the property casualty and life annuity and disability income marketplace. So it cements for us a very positive business formula for ongoing success.

Now, as Phil shared with you, we are currently experiencing difficulty with, as he referred to them, worker's compensation and multi-peril-type exposures. But I’m confident that we will be able to turn those results with the efforts that have been underway and will continue to be initiated. So, Charlie, I think going forward, having both the personal and the commercial marketplace at the Erie, is a strong formula for our ongoing success.

Could I ask one more question? This is my last one. Doesn't the action you've taken with regard to restructuring the portfolio, the increase in your surplus, and the underwriting and repricing of your book of business lead to a situation potentially where tomorrow or in the future you won't have to adjust downward the management fee again?

Certainly. I would hope that result to occur, meaning that our goals for improved underwriting profitability put this organization in an even stronger position to make that potential decision.

Hey, thank you.

Thank you, Charlie.

Take care.

Our next question comes from [Charlie Smith][ph] with Fox-Pitt. Go ahead, please.

Hey, good morning. That's Fort Pitt Capital. Couple questions on the reinsurance business. Do you anticipate any special charges between now and year-end on the exit of that business? And, second, how long is the potential tail on that business? I mean when will you know -- within what kind of timeframe would you know that all the risks have gone away from that business as far as your book is concerned?

First of all, in the Q, we do report -- there's a new FAS out, FAS 146, where you have to report when you exit a business what your exit costs are. We did report -- we did analysis of that, and we did report that we do not believe there will be a charge associated with exiting the reinsurance business in 2003.

Okay.

So you can read the Q and that's in there. Remind me, what was the second part?

Potentially, is there any kind of a tail to that business in terms of --?

Yes, that's right. First of all, it's mostly property business.

Okay.

So it's going to have a two- to three-year tail. Now, the one exception to that is the reserves we have up, which we disclose, for the World Trade Center terrorist act, the $150m. That has not developed, you know, as fast as anybody in the industry thought it would develop. We report where we are on that. You know, I don't know how long that tail's going to go. But in any case, we believe our reserves at $150m are adequate for that World Trade Center catastrophe in any case.

Okay.

Even in a two-scenario case, you know, two-incident scenario case.

Okay. Thank you very much.

Um-hmm.

Our next question comes from [Ron Bobman][ph] with [Capital Returns LP][ph]. Go ahead, please.

Hi, Jeff. Hi, Phil.

Hi, Ron.

Good morning.

Hi. I had a question. What's GAAP equity for the exchange at June 30?

Well, in the Q, we show you what the equity is.

I thought it was only stat surplus that was disclosed. Is the GAAP equity also in there?

No. Well, to GAAP the surplus of the exchange, you've got to do a whole bunch of calculations. First of all, the bonds are carried at amortized cost, so you've got to mark them to market. That's several hundred million dollars. You've got to record salvage and sub, which we do not record. You actually had the option to record salvage and sub receivables at a balance sheet date --

Right.

-- under stat accounting. We take a very conservative approach and do not. So our salvage sub receivable is probably close to $100m. I'm trying to think what other adjustments there would be.

But you're talking about at least another 10 percent to --?

Well, you have to also take the effective taxes off those numbers. So take 65 percent of those two.

As it relates to this FAS 46 accounting pronouncement --

You're talking about FIN 46, the FASB interpretation?

Excuse me. Yeah, and the possibility of the consolidation. If I look at this correct, would that add over 30-some-odd dollars of book value to Erie Indemnity Company's report -- it would be reported, of course -- GAAP equity?

Well, first of all, as we report in the Q, we do believe that the exchange is a VIE, a Variable Interest Entity --

Right.

-- under that interpretation. However, we have not yet concluded, and there's a -- if you read 46, there's a test that has to be performed regarding whether you consolidate a VIE or not. And it's a pretty extensive test that has to be done. We're not there yet, and it's an open issue as to whether we would have to consolidate.

Now, as to your question as to whether -- how much equity if we did consolidate would be added, well, first of all, when you consolidate the exchange, what you're going to do is you're going to show a minority interest equal to the GAAP equity of the exchange on the balance sheet because that's not our GAAP equity. That's the policyholder's.

Okay.

So we would not show that as ours.

Okay.

The book value of indemnity would not go up.

Okay. And the last question I had relates to the plan or the prospect for an additional surplus note to be issued to EFL. And I’m wondering if third parties or other capital sources were solicited, and with the plans to reduce the equity exposure of the investment portfolio at, I guess, at the exchange and reduce the insurance risk, does this run counter to that, really sort of increasing your private illiquid security exposure?

Well, first of all, the surplus note's going to be made by Indemnity, not the exchange.

Um-hmm.

And we're committed to doing that. In fact, it's in progress right now, so we are going to make the surplus. We are going to issue the surplus note. Erie Family Life and Erie Indemnity Company is going to buy the note so -- for $25m.

Is that going to be continuing -- is Erie Indemnity a continuing source of equity capital for Family Life as it grows?

We deliberate on the capital source as to whether -- traditionally -- well, this is the second time we've done it, so two out of two times, it's been indemnity, but it's not necessarily the case. We think about our entire capital picture when we have to capitalize these subs.

Okay. Thanks a lot, and good luck.

Okay. Thank you.

We'll take our final question from [Pat O'Brien][ph] with [Alex Brown Investments][ph]. Please go ahead.

Hi, Pat.

Hi, guys.

Good morning.

You know, I own this stock because I think you've got a tremendous personal lines franchise here, and I just -- I wonder if you can say some more about Charlie's question. Why do you write this combined ratio? Or why do you write this commercial stuff? You know, 122 combined ratio, it's been a while since I looked at what the industry's doing for worker's comp, but that looks really bad. That looks like adverse selection. This is sort of the -- you know, it's like the personal lines' evil twin.

Interesting characterization. Pat, I would expand my comments in response to Charlie by going back to the point, though, about what it enables us to do. You know, at any given time, and admittedly even over the course of maybe multiple quarters, one can take a snapshot and say, "Why do you do this or why do you do that?" Earlier today, I referenced back to where we were in 1990 when we made decisions involving spreading our company by product line, by territory, and even by operation, and thus started an assumed reinsurance business. We recognized back in 1990 that we had a strong reliance on personal lines. Upwards of just 80 percent -- roughly 80 percent of our company at that time was personal lines, and predominantly automobile, and predominantly, Pennsylvania automobile.

And in 1990, we had a very significant event occur in the form of Act Six, where regulatory change required mandatory rate rollbacks. It challenges the consistency or the ability to produce consistency -- consistent results, rather, when you have such a heavy reliance on a single product, a single state, or in the case of this example, a single grouping of products' personal lines. So the commercial/personal balance allows us over the long term to produce consistent, stable results. Now, it does look ugly, but we can improve it, and we will. The valuation efforts in both personal and commercial lines are having a positive effect. The commercial marketplace, I believe, is interesting in that some of the prices are finally reaching back to price levels that existed in 1996 and 1997 because they went down to some very competitive low levels in the late '90s and early 2000 and then started, of course, turning up sharply, and they haven't reached the adequate rates, in some cases, which will enable those high combines to come down to more appropriate, profitable levels.

So I think it's important that we maintain that full loaf, if you will, for our agency force, which, again, contributes mightily to the revenue stream of this organization and the entity, Erie Indemnity Company, in the way of management fee. And if you limit yourself to, let's say, a half a loaf by offering only personal lines, you invite competition into your independent agencies, competition that comes initially in the form of a commercial writer who decides that market conditions are such that they'd like to dip their toe into the personal lines market, and in so doing, potentially could take away market share and have a very significant snowballing effect on our agencies and the collective result of our agencies. So I think it's a strong formula. It's going to require and has our focus and will be a good formula going forward.

You know, and just to follow up, we had some very -- you know, some large losses in the quarter in some of our commercial lines, some shock losses, that are affecting the second quarter numbers that I told you about. This is basically Main Street commercial and small commercial that piggybacks, as Jeff said, very nicely with our local agents' personal lines efforts. And many times, this small commercial businessperson, that's the entrée into the account for our personal lines. But just to reiterate that we did have some shock losses in those lines during the quarter.

Okay.

Thanks for your question, Pat.

Thanks, guys.

Pat, thank you. And thanks to everyone else for all the great questions and the conversation that it stimulated. We appreciate that. Just to remind you that the recording of the call will be posted on our website, ErieInsurance.com, after 12:30 Eastern Time today. If you have any questions at all, please call me -- 814-870-4665. Sue and I will be available offline to talk to you later today. But thank you again, and have a super day.

Thank you. Again, that does conclude today's conference call. We appreciate your participation, and you may now disconnect.