Erie Indemnity Co (ERIE) 2003 Q3 法說會逐字稿

Hello. And welcome to the Erie Indemnity Company third-quarter earnings conference. At the request of Erie Indemnity, this conference is being reported 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 would like to introduce your host for today's conference call, Karen Krauss Phillips, Vice President and Manager of Corporate Communications and Investor Relations.

Thank you, Nicole, and good morning everyone. We really appreciate you joining us on today's call. On today's call, management will discuss our third-quarter 2003 results. Joining me are Jeff Ludrof, President and CEO, Executive Vice President and Chief Financial Officer, Phil Garcia, and Jan Van Gorder, Senior Executive Vice President and General Counsel. Today's prepared remarks will be approximately 30 minutes. Following those remarks, we will open the call for questions. We 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, the 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 such as 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 statement in our latest 10-Q filing with the SEC, dated October 29th, 2003 and in the related press release (indiscernible) 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 1:30 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 at this time. Thank you. I would now like to turn the call over to Erie's President and CEO, Jeff Ludrof. Jeff?

Thank you, Karen. Good morning, everyone. And thank you for joining us on today's call. As Karen said, the earnings release was issued late afternoon yesterday. I'm sure most of you had an opportunity to review the release and may have a number of questions. So, we'll try to get to those quickly. As the release indicates, Erie Indemnity Company had a strong third quarter with net income up by more than 21 percent to 79 cents per share. Net income, excluding net realized gains or losses on investments and related income taxes, was up by 12.8 percent to 78 cents per share. I would like to talk about the factors that affected our third quarter performance, bring you up to speed on our underwriting profitability initiatives and their effects on our growth rates. Phil will be reviewing the quarterly results, and talk a little bit about the application of FIN-46 to our financial statements.

While the Erie Indemnity Company had a strong quarter, the Erie Property and Casualty Group experienced significant losses driven by catastrophes during the third quarter. The damage caused by Isabel resulted in more than 17,000 claims -- our most significant natural catastrophe ever. Estimated direct losses incurred from Isabel through the third quarter were $70 million. Additional catastrophes, including previously-reported, severe wind and hail events in Pennsylvania, added another $40.1 million. As a result, our statutory combined ratio for the group for the third quarter 2003 was 117. When adjusted for the profit portion of the management fee paid to the indemnity company, which provides a more accurate comparison to our competitors, the combined ratio is 110.5. Excluding catastrophes, the adjusted combined ratio for the third quarter is 98.5, as Katz (ph) added 12 combined ratio points to the total.

The service response to Isabel by our employees and agents was nothing short of phenomenal. When the effects of hurricane Isabel became reality for our policyholders, Erie employees and agents readily responded with immediate and exceptional service. Two days before the hurricane hit Erie's new catastrophe response unit was dispatched to a holding area near the path of the storm. The response unit serves as a mobile, self-supported claims office at the sight of a disaster. As Isabel moved up the Eastern Seaboard, Erie adjusters, property specialists and material-damage appraisers arrived from every Erie branch to support the agency force and policyholders in the hard-hit areas. Home office and field office employees staffed phones and call centers, taking loss reports around the clock and following up with policyholders. On Sunday, September 20, only two days after the storm made landfall, our claims management reported that at least 95 to 98 percent of policyholders had received an adjusted response for claims that had been filed on that previous Friday. In addition to responding to the claims reports, branch employees and agents distributed comfort kits through Erie's Serving Together Alliance with the American Red Cross. This three-year-old partnership links Erie employee and agent volunteers and resources with the needs of Red Cross chapters throughout our territories.

What happened in Maryland is another telling indicator of our services response. When the Maryland Insurance Administration asked insurers to attend town hall meetings to respond to customer complaints, Erie had a desk right upfront, and received no complaints. We don't advertise. Word-of-mouth is our most effective tool to build customer awareness and loyalty. People expect service. They expect value. And that's exactly what Erie provides to them.

Confirmation of that fact, again, came from the recent J.D. Power and Associates' 2003 Homeowners Insurance Study. In the survey of customer satisfaction, Erie ranked nationally as the number one independent-agent represented company for the third year in a row and the number two company overall for customer satisfaction. Our above-all-in-service response to hurricane Isabel and the national recognition we achieve year after year, support our strong business model of operating through agents and employees. The service success provided by this business model has a positive impact on our retention of business and our ability to achieve quality growth. Now, I want turn my attention to underwriting profitability.

Earlier this year I shared with you our four point plant to enhance underwriting profitability of the Property Casualty Group. The plan targets the following strategies -- managing exposure growth, improving risk selection, controlling loss severity and maintaining appropriate pricing. Specific actions are underway throughout the organization, aimed at improved, underwriting experience. While hurricane Isabel and other shock (ph) losses have driven our higher-than-expected loss results, progress is being made on our underlying performance. On previous calls, I have talked about our AWARE program, which stands for agents writing and re-underwriting excellence. Through this program, we are asking our agents to rededicate their efforts to conscientious underwriting and continuous re-underwriting. Our goal is to ensure we are getting the better risk and the appropriate premium. For example, our agents have caused a shift in auto premium classifications through their focused attention on underwriting and re-underwriting activities. This has led to obtaining more adequate premium for exposures, in addition to the rate changes filed within each territory.

Our claims division has numerous initiatives aimed at controlling loss severity. These include Specialty Claims Units for uninsured and under-insured motorist claims, specialization for property claims handling and focused efforts on controlling workers' compensation severity. In addition to these underwriting profitability initiatives, we continue to accelerate rating actions throughout our territories. At the close of the third quarter, our 2004 estimate of rate change impacts grew to 343 million, up from $229 million at the end of the second quarter 2003. Our estimate includes rate increases approved, filed and waiting approval, as well as those planned -- but not yet filed -- for 2004. The increases are related to our private passenger auto, homeowners', workers' compensation and commercial packages. These changes translate into average premium increases of 9 to 10 for 2004.

As part of our underwriting profitability focus, we continue to be manage our exposure growth. As expected, our revised underwriting guidelines for new business are resulting in a decline in new policy premium growth rates. Unit growth rates have declined from the very high levels we saw in 2001 and 2002. Additionally, we continue to re-underwrite our existing book of business, which is reflected in a modest decline in our year-over-year retention rate in the third quarter of 2003, moving from 91 at the end of the second quarter to 90.6 at the end of the third quarter of 2003. Again, this is an expected, short-term result that will yield greater long-term underwriting profitability.

During the third quarter, we announced changes in our agency compensation program with the intention of providing further incentives for agents that achieve exceptional profitability in property casualty business they write with Erie. We've implemented modest decreases in our workers' compensation and commercial multi-payor (ph) commission rates. And we have enhanced the payouts under our contingency program to reward exceptional underwriting profitability and to incent quality growth. These are important changes to our agency compensation program that we believe further align our long-term profitability goals with the expectations and rewards we have for our agents. All in all, our organization is busy but very focused on the fundamentals in all our disciplines. With a strong culture of dedication and commitment, our agents and employees are generating positive momentum on our plans toward improved underwriting profitability. Now I will turn it over to Phil to talk about more about these effects and a review of the third-quarter financials.

Thanks, Jeff, and good morning, everyone. As Jeff remarked, the third quarter was a strong one for Erie Indemnity Company. For the third quarter 2003, net income increased by 21.8 percent to $56.2 million or 79 cents per share, compared to $46.2 million for the third quarter 2002. Net income, excluding the effects of net-realized capital gains and income taxes on those gains, rose 12.8 percent for the quarter to $55 million, up from $48.8 million for the same quarter in 2002. This represents an increase of 12.8 percent to 78 cents per share, versus 69 cents per share for the second quarter of 2002. As I review the management operations, you can refer to the exhibit, Consolidated Statement of Operations, Segment Basis, which was included in the supplemental data issued with the press release.

First, I would like to discuss our performance in our management operations segment. Management fee revenue grew by 10.8 percent to $231.7 million for the third quarter 2003, compared to $209.1 million in the third quarter of 2002. Management fee revenue continued to grow at a slower rate in the third quarter 2003 than the increase in premiums written, due to the action of our Board of Directors on January 1st, 2003 to reduce the fee rate from 25 percent to 24 percent. Direct-written premium in the third quarter grew by 16.1 percent, totaling $971 million, compared to $836.3 million a year earlier -- down from 17.9 percent premium growth in the second quarter 2003. Year-over-year policies-in-force growth was 9 percent -- down from 11 percent in the second quarter 2003. The year-over-year increase in average premium per for policy was 9.9 percent. In addition, as Jeff mentioned, our year-over-year policy retention ratio declined slightly, from 91 at June 30th, 2003 to 90.6 at September 30th, 2003.

As a consequence of our focus on underwriting profitability initiatives, written premiums on new policies decreased by 20.6 percent overall for the quarter, from the very high new policy premiums written in the third quarter 2002. Personal-lines, new policy, written premium decreased by 13 percent, while commercial-lines, new policy written premium decreased by 33.9 percent for the three months ended September 30th, 2003, versus the same in the prior year. As Jeff pointed out, this direction is in line with the necessary steps we have taken to pursue more profitable business. Our more aggressive rating actions in the latter part of 2003 and 2004, will partially offset the impact on premium volumes related to these anticipated declines in new unit growth. Service agreement revenue increased for the third quarter of 2003 to $6.7 million from $1.2 million during the third quarter 2002. Included in the service agreement revenue are service charges the company collects from policyholders with providing extended payment plans on policies. The service charge revenue for the third quarter 2003 was $5 million, compared to a charge of $2.3 million for the same quarter a year earlier. Remember that included in the third-quarter-of-2002 results is a one-time charge of $7.4 million taken by the Company to adjust service-charge revenue to a build basis. Also, included in service-agreement revenues is the service fee income received from The Exchange as compensation for the management and administration of a voluntary-assumed reinsurance from non-affiliated insurers. These fees decreased substantially during the second quarter of 2003, due to actions taken to discontinue unprofitable treaties and to continue winding down the assumed reinsurance business by January 1st, 2004. Service agreement revenue was also affected by the reduction in the service fee rate, from 7 percent in 2002 to 6 percent in 2003. The reduction in service fee income on voluntary-assumed reinsurance premiums written by The Exchange was down 52 percent to $1.7 million in the third quarter 2003 from $3.5 million in the third quarter of 2002. Voluntary-assumed reinsurance premiums decreased to $27.7 million in the third quarter of 2002 from 49.7 million in the third quarter of 2002.

The cost of management operations increased by 17.2 percent in the third quarter to $169.8 million from $144.8 million for the same period in 2002. Commissions paid to our independent agency force account for the majority of these costs. Commissions cost totaled $125.2 million for the third quarter of 2003 -- an 18.2 percent increase over the 105.9 million recorded for the third quarter of 2002. This was driven primarily by the 16.1 percent increase in direct-written premiums that I referenced earlier and the increased charges for agency-contingency bonuses for the quarter.

As Jeff mentioned, during the quarter we announced changes to our agent-compensation program which will affect the agent-contingency bonus program and some commercial commission rates. We expect changes to commercial commissions to reduce commercial-commission expense by approximately $15 million annually based on 2003 commercial premiums written. The majority of the savings is being used to enhance the agency-contingency bonus program. Even with the proposed changes to commercial commissions, Erie's commercial commission rates remain competitive. Changes to the agent bonus program will be effective in 2004. Commercial commission rate changes will be effective January 1, 2005.

Other operating expenses, excluding commissions, increased by 14.5 percent to $44.6 million, compared to $38.9 million a year earlier. Personnel costs, including salaries and wages, employee benefits and payroll taxes, which encompass the largest component of other operating expense, increased 16.2 percent to $25.6 million for the third quarter of 2003, compared to 22 million for the same period in 2002. The increase in personnel cost was driven by salary and wage growth of 10.2 percent and increases in employee-benefit expenses, driven by higher medical and retirement benefit costs. The company self-insures its medical benefit plan for employees, and experienced higher utilization rates and shot (ph) claims during the quarter. The Company continues to report increased costs for employee-retirement benefits under its retirement plans, due to lower plan asset return and discount interest rate assumptions. In the third quarter of 2003, pension plan costs increased about $800,000 to $1.8 million. The gross margin from management operations was 28.8 percent for the third quarter. The management fee and service fees were same as last year. The gross margin would have been 31.7 percent at the end of the third quarter 2003, compared to 31.1 percent in the third quarter of 2002. The company share of information technology, hardware and infrastructure expenses related to the Group's e-commerce program, totaled $.1 million and $.2 million in the third quarter of 2003 and 2002, respectively. For the first nine months of 2003, these cost totaled $.3 million, and will continue to be incurred in future periods as the program develops.

Next, I would like to discuss our insurance underwriting segment. As you know, the Erie Indemnity Company's property-casualty insurance subsidiaries retain a 5.5 percent share of the underwriting results of the Property and Casualty Group. As Jeff explained earlier, the Group's reported, statutory combined ratio for the third quarter of 2003 was 117, as the result of significant catastrophes, including hurricane Isabel. The catastrophe reinsurance program we put in place to protect against losses from wind events such as Isabel, was not triggered because losses did not exceed $115 million -- the attachment point for the program. Erie Indemnity Company's reported GAAP combined ratio for the third quarter was 110.2, compared to a combined ratio of 114.9 during the same period in 2002. In total, Erie Indemnity Company recorded underwriting losses on a net basis of $4.9 million in the third quarter of 2003, compared to losses of 6.3 million for the third quarter of 2002. The gross underwriting loss for indemnity was offset due to the effect of the aggregate excess-of-loss reinsurance agreement the Company has with The Exchange. The third quarter of 2003 included reinsurance recoveries of $7.1 million under this reinsurance agreement, triggered primarily by catastrophe losses in the third quarter.

Investment operations recorded income of $19.8 million during the third quarter, compared to 10.7 million for the same period in 2002 -- an increase of 84.5 percent. The increase was driven by net-realized gains of 1.8 million in the third quarter of 2003, which reflected no impairment charges compared to net-realized losses of 4 million dollars in the third quarter of 2002 that included 7 million of impairment charges. Net investment income increased by 4.4 percent to $14.5 million for the third quarter of 2003 from 13.9 million for the third quarter of 2002.

The company also recorded equity and earnings from limited partnerships in the third quarter of 2003 of $1.3 million, compared to earnings of $.8 million in the third quarter of 2002. This was due primarily to income from real estate limited partnerships of $1.4 million for the third quarter of 2003, which was offset by losses in private-equity and fixed-income limited partnerships of $.1 million. In the third quarter of 2003, there were impairment charges related to private-equity limited partnerships of $.6 million. The Company's earnings from its 21.6 equity ownership of Erie Family Life increased to $2.2 million in the third quarter of 2003 from $.1 million for the third quarter of 2002. Continued strong increases in policy revenues, net investment income and net-realized capital gains contributed to this significant improvement in results for the third quarter of 2003. Before I turn the call back over to Karen and open for questions, I wanted to review the effects of FIN-46 on the Erie Indemnity Company.

Many of you know that the Financial Accounting Standards Board or FASB issued interpretation No. 46, better known as FIN-46 Consolidation of Variable Interest Entities (ph). Interpretation introduces a new consolidation model that is broad in scope and extremely complex. It provides guidance for determining when an entity's equity holders have adequate decision-making ability, thereby identifying entities for which control is achieved through means other than through voting rights. These entities are called variable interest entities or VIEs. We have determined that the Erie Insurance Exchange is a VIE, based upon current guidance. The guidance requires consideration of fees paid to decision makers when determining who receives the majority of the variability of the gain or loss from a VIE. Considering the management fee The Exchange pays to the Erie Indemnity Company, we have been concluded that Erie Indemnity Company is the consolidating entity. Therefore, based on current guidance, the Erie Insurance Exchange must be consolidated for SEC financial statement reporting purposes with the Erie Indemnity Company.

As a consequence of consolidating The Exchange, the Erie Family Life Insurance Company will also be consolidated with Indemnity due to their combined ownership interest in Erie Family Life. FIN-46 takes effect for financial statements as of December 31st, 2003. While it will dramatically change the presentation of the Indemnity Company's financial statement, we do not believe it will change the Company's reported net income, net income per share, shareholders' equity or book value per share. Over the next several months, Karen and I will be talking with the investment community, so you can gain an understanding of the new consolidated financial statements of the Company. In addition to the new consolidated general-purpose financial statements, we will continue to provide detailed, financial information for Indemnity in a format that you are currently familiar with. It's important to us that you have a comfort level with the financial statement, and can easily derive the information you need for your analysis of the Company's performance. You will be hearing more about these efforts in the next several weeks. Now, I would like to turn the call back to Karen.

Thanks, Phil. Nicole, could you please now open the call for questions?

(OPERATOR INSTRUCTIONS) We will pause for just a moment to compile the Q&A roster. Your first question comes from Adam Klauber of Cochran Caronia.

Good morning. Could you talk a bit about the agency force -- the force at (indiscernible) in 2001 - 2002? What are your plans to grow the force in 2004? And, also, could you give us some idea -- obviously the business is still growing a fair amount -- how much of that is coming from the agents hired in 2001 and 2002 and how much is coming from the existing agency force? Thank you.

Adam, as it relates to the 2004 plans for new agents, we're still in our process of modeling our 2004 plans for the organization. We expect to continue those modeling efforts, discuss them with our board at our December meeting, and following our December meeting, as we have done in the past, we will issue a press release on other related issues, including our growth plans for 2004. As to the percentage of business coming from new agents versus -- what we have referred to in the past -- same-store sales or existing agents -- maybe agents with us greater than three years -- we are seeing strong growth from both categories. The efforts that have been made to improve the same-store sales from existing agents have had a noticeable impact on the growth in our business through the past several years, and certainly, have had a positive impact on our renewal business throughout 2003. I don't have specific figures in front of me to answer your question more specifically. I can tell you that we are seeing positive growth from both the new agents as well as the existing agents.

Thank you. Could you give us some idea how is the morale of the agents as you put in the new underwriting guidelines and the new compensation guidelines?

I would describe the morale of our agency force as a group of individuals, much like our employees, who are extremely busy. Who are challenged by significant changes regarding our industry, changes in our company regarding revised underwriting guidelines, compensation programs. The morale over all remains strong. Anytime you broach the topic of compensation, you certainly gain the attention of people, and we have done that with changes that we have announced to our agency compensation program. But I personally visited with all of our agency owners in the past 30 days. And as we discussed the changes and explained the reasons why the changes were made, answered questions and comments and helped agents better understand all the components of the agency compensation program, the agents became more supportive of the changes. I think we've always had a very strong relationship with our agents. And while certainly changes and challenges have added to the stress, if you will, the relationship remains very, very strong.

Thank you very much.

Your next question comes from Charles Gates of Credit Suisse First Boston.

Good morning. My first question -- in the initial remarks, you made reference to the fact that the difference between -- if you look at the combined ratio of The Exchange, which I believe was 117, on an adjusted basis relative to other companies, it's 110? And you got to walk me through that one more time, explaining that to me.

It's on a statutory-group basis, Charlie, it's 117. If you exclude caps from that number, we had 12 points of caps -- $110 million. Really a year's worth of caps -- a typical year's worth of caps in one quarter for us. So if you take the 117 and take those 12 points off, you have a 105. And then in that combined result is the -- is a margin for Erie Indemnity Company of 6.5.. That's the process in the management fee.

Okay.

So if you take 105 minus 6.5 you get 98.5, and that's the math.

So that -- (multiple speakers)

That puts on us a non-GAAP (ph) apples-to-apples basis with industry-reported results.

So on this adjusted basis -- say if you were some other company -- you would have reported a 98.5 during the period?

After catastrophes.

Okay.

After catastrophes. Because we -- obviously we had a very bad catastrophe quarter.

My follow-up question -- to what extent have you raised auto insurance rates -- personal auto insurance rates -- in Pennsylvania? And in answering that question, how has your position in the market changed? What I meant by that -- this is my last question -- you used to, I believe, have lowest insurance rates in like 64 or 65 counties.

Right. We are taking a rate change in Pennsylvania automobile of 7.1 percent in the beginning in January. I believe it's around a $60 to $70 million increase. We do that -- when we do that, we take a look obviously at the competitive position of our company after the rate increase, relative to our competitors. And we believe we are still in a good competitive situation in Pennsylvania automobile with that rate increase.

Thank you.

Your next question comes from Hugo Warns of J.P. Morgan.

Hey, good morning, this is Dave Schuze (ph). A couple of quick questions here. First, can give us update on the disposal of the reinsurance operations?

Yes. We continue to wind it down. We made some inquires around whether -- as you know, this is brokered business where we're not the lead on any account. But we made some inquiries about whether there was anyone interested in, perhaps, purchasing the renewal rights to the book and there were not. So, we're continuing to just wind down the business.

Okay. And moving onto FIN 46 -- in regards to the risk profile of the business, do the economics of Erie Indemnity change or how are you feeling with the underwriting risk side of the financial reporting changes?

Well, nothing really changes. All the same legal relationships are still intact. What we will be doing is consolidating The Exchange and Erie Family Life into the financial statements of Indemnity. The problem with that is that Erie Indemnity's financial statements will like that of a property-casualty insurer. Our balance sheet will look that way. And our income statement will look that way until you get back to -- and this aggregates the combined group back to Indemnity. So, we are going to look like a much larger entity. But we are going to look like a property-casualty insurer. And that -- I think that's problematic. So what's incumbent upon us is to do a great job surrounding these financial statements with MD&A and notes that explain what Indemnity is and what the Indemnity shareholders' own and the fact that this is a management company for this Group. So, we will do the best job that we can at disclosing that.

And that information -- (indiscernible) back data and reclassification is going to come out in the -- I guess, around February right?

Right, we will be restating all of the comparative financial statements for 2002 and 2001 on this new consolidate basis.

Okay. And last question, and I will hand out the floor to somebody else. Just on the personal-line side -- can you give us a sense of where lost-cost inflation is running on your underlying book of business?

Yes. In our personal lines, you got to break that down between basically auto and home. We track -- obviously, we track our severity on the auto book, which is our five-year severity is in the 5 percent range. On homeowners, it's much higher. It's in the mid-teens on a five-year basis. So our challenge is to manage the severity on the homeowners line from a perspective of personal lies.

Great. Thanks so much.

Hey, Phil and Jeff, it's Hugh. Can I just have one follow-up question?

Absolutely.

Philip, now from your accounting standpoint, I'm a little bit surprised that you're going to do this through the FIN-46 (indiscernible) -- are you guys just being super, super conservative in the way that you're looking at it? I mean have you talked to a couple different firms, because I know this is all very squishy rules --

Yes, it's a very complex interpretation. We came to that conclusion internally. And our auditor came -- also agrees with the conclusion. (multiple speakers)

Who is the auditor right now?

Pardon.

Who is your auditor right now?

Earnst and Young. And we obviously did not shop around for an opinion on that because that would not be -- you can't do that.

Right. Okay, I was just curious because I know you guys have always been very conservative in the way that you look everything, and I did not know if it was kind of a question of just trying to be as straight and narrow or kind of absolutely double interpretation has proven this.

Well, this year we also consulted with the SEC. They did not object to our conclusions.

They are the boss.

Hey, we appreciate it.

You know we have debated it quite a bit in studying the whole interpretation. Here, internally, we don't think it's necessarily a good thing because it kind of muddies what Erie Indemnity Company is in terms of it being the management company and receiving most of its income from management fees. But we'll get the disclosure just right so everybody understands that.

Alright. Great. Thanks.

Your next question comes from Beth Malone of Advest, Inc.

Okay. Thank you. Good morning. I have two questions. First on the reinsurance agreement between The Exchange and the Indemnity Company -- that resulted in the Indemnity Company not incurring any of the losses from hurricane Isabel.

Right.

Does that reverse itself in the fourth quarter if you don't have any more events -- catastrophic events? Or could you explain -- is there any possibility that we have to account for those losses later?

Yes, that's a distinct possibility. The accident year -- 2003 accident year -- of the 7.1 million recoverable we recorded in the quarter, about 6.6 million of that recoverable was from the 2003 accident year under that agreement. We account for that agreement by accident year. So if we have a -- which are hopeful we have -- a good underwriting result in the 2003 accident year in the fourth quarter, part of that $6.6 million recoverable could be reversed, which means those losses would come back to Erie Indemnity Company.

So the fourth quarter results could be lowered if your loss experience actually improves?

Correct. If our loss experience improves at the pool, that's great. And we'll get 5.5 percent of that. But you also have to take into account what happens to the 2003 accident year under the aggregate excess-of-loss (ph) re-insurance agreement between the Companies. And that would result in some reversal of the recoverables we have booked here in the third quarter. Correct.

Alright. The second question -- on the service agreement that you have between the Indemnity Company and The Exchange, does that agreement get reviewed annually? And what factors do you take into consideration? What's the timing of that review? And what factors do you take into consideration in considering what are you going to change the amount that goes to the Indemnity Company?

You're not talking about the management agreement? You're talking about the service agreement?

(indiscernible) of the 24, 24 on that.

Okay, you are talking about the management agreement. Yes, we set that every December as part of our planning process -- our forecasting and planning process with our Board. And we will be doing that again at the early December Board meeting, and we will have a press release with respect to what we're going to set it at for 2004. And as we have said in the past, it is really a judgment call of the Board of Directors. And the things we look at are the operating earnings growth of Erie Indemnity Company and the surplus growth and financial strength of Erie Insurance Exchange, opposed against each other.

Finally, on that -- you had announced earlier that were -- and you talked about restructuring the agency force with not going into new states right now. Is that still on track or (indiscernible) see an extension of that into 2004 about slowing down the expansion plan?

Beth, that still is on track. The announcement, of course, was that we had plans to start writing business in Minnesota in September of 2004 or in the fourth quarter of 2004. And we postponed those plans with no date set. Just as I mentioned earlier, as part of our formal planning process for 2004, we're currently going through that process and will review that process in our recommendations to our Board in December. So later this year, we will be able to great give greater guidance on that.

Okay. Thank you.

Your next question comes from Dan Deriault (ph) of Johnson & Company.

Good morning. I'm just a little unclear on FIN 46, and how it doesn't increase the volatility of your results. For example, the excess-of-loss reinsurance agreement between Indemnity and The Exchange -- wouldn't that eliminate upon consolidation? And what would happen to the management fee? Does that eliminate upon consolidation as well?

Well, they eliminate on consolidation. But then when you calculate the minority interest of Exchange and the minority interest of the EFL that needs to be backed out of the income statement to determine what Erie Indemnity Company's net income is, you would need to consider all those legal relationships that are still in place. One of the -- go ahead.

So, basically, we would show consolidated entity and then have a minority-interest entry bottom line to get the bottom line for Erie Indemnity.

Actually, what we will get is a consolidated NIL (ph) -- your correct that the consolidated net income line, we will emanate a lot of intercompany relationships, including the main one, which is the management fee relationship. That will all be eliminated in the consolidated net income on the income statement. We will then back out a minority-interest, net income of Erie Insurance Exchange, net income of Erie Family Life Insurance Company and be left with the net income of Erie Indemnity Company, which will not change.

Okay, and that's a one-line item below the operating line?

Correct.

The second question is how will the rating agencies look at you from a capital perspective? In other words, part of the allure of investing in Erie Indemnity has always been the thought that you had excess capital at the parent. And there has always been some implied support between the parent and the insurance company. Will the rating agencies -- now that you're consolidating from a financial standpoint -- just say, hey, the lines have really blurred and you really do not have the excess capital that we thought you did?

Well, actually, the rating agencies don't even look at Erie Indemnity Company. In fact, up until a year ago, SMP did not even know -- understand relationship that Erie Indemnity Company had with The Exchange. They basically look at the insurers themselves -- The Exchange the Company, Erie EIP&C. And in the case of The Exchange and S&P, they didn't even realize that Indemnity was the management company for The Exchange and had a billion -- over $1 billion in capital off to the side. So, they really will not even look at these -- I don't believe they will look at the consolidated financial statement of Indemnity. They'll continue to look at our stat (ph) statements for the insurers.

Okay. Thank you.

Your next question comes from Rob Baubman (ph) of Capital Returns.

Hi. Most of my questions have been answered. But I'm trying to get some sort of insight as to the prospects of the management fee being tweaked at the end of the year or following the December board meeting. And I am wondering from management's perspective, do you feel The Exchange, following the third-quarter end, with its writings relative to surplus and with its operational change that you've made with respect to production and reducing some of the markets that you're going after, are slowing the rate at which you're entering new markets -- rate changes? Do you feel that The Exchange is a stronger entity now that was at the last year's point in time when the management fee was reviewed and adjusted? Thanks.

Well, certainly The Exchange has undergone significant challenges this year. The catastrophe experience and shock loss experience that we referred to in this call, have put significant pressure on The Exchange. These results are unacceptable. The initiatives that I mentioned to improve the underwriting experience, underneath those high-level results, are having a positive impact. So there are some offsets to the challenges. The high-level numbers are clearly unacceptable. The underlying performance certainly improving. So there is a balancing act of results and initiatives taking place. In terms of trying to give any further insight as to what changes might be made -- that would be inappropriate. Certainly, it's an issue that we need to discuss with our Board, and will do so at our December meeting. And, of course, we will announce that to you immediately following that meeting in a press release.

Thanks. And as unrelated follow-up -- is the Board or will the Board and management consider any sort of action to exempt you from the consolidation -- I am sorry, is it FAS 46?

FIN-46.

Sorry, 46 FIN -- is that on the table in any form or fashion?

No. We would have to make a fundamental -- some fundamental changes in the interrelationships between the entities to do that. And that -- those are not -- we are not contemplating those. No.

And lastly, if you will oblige me -- any changes -- any developments on the family feud front? With the controlling shareholders?

Nothing. In fact, all relations appear to be going well.

Okay. Thanks a lot, and best of luck.

(OPERATOR INSTRUCTIONS) There is a follow-up question from Charles Gates of Credit Suisse First Boston.

Charles Gates; I'm sorry, guy. My follow-up has been answered. Thank you. Hey -- you want to speak to the competitive environment -- is it evolving in personal auto and homeowners, your principal markets?

Sure, Charlie. We see a very competitive marketplace out there right now -- very competitive in the sense that everyone is focusing on trying to write a very best business. Certainly those that are in the preferred risk business, that is. So we do see some softening taking place out there in the marketplace. But as I indicated, we anticipate average premium increases next year in the 9 to 10 percent range across all lines for our policyholders. We have had and expect to continue to have a strong competitive position out there. Certainly, it has been very challenging for our agents, narrowing their focus on the most desirable business. But we feel confident that we can continue to execute our business model and maintain our relative competitive position going forward into 2004.

Thank you.

Your next question comes from Ira Vallas (ph) of Legg Mason.

How are you doing? Two questions -- totally unrelated. The first one is, can you just give a kind of a 30,000 foot overview on what's going on with the e-commerce initiative? I mean, what are some milestones that we're looking at? How is it going? It's just kind of hard to get a read on it from the outside.

Sure. First of all, I am very pleased to announce that this Monday, November 3rd, we're actually going to release a very important release of Erie Connection. We're going live with a pilot group of agents and employees -- a huge milestone in the development of Erie Connection. And we continue to make significant progress toward going beyond this milestone on Monday. But our employees -- our agents have been very patient, and our employees and everyone has worked very hard to bring this milestone on Monday. And we're very excited about that, and we're very encouraged about continuing to move forward on the project.

Well, that is good to hear. Second question, your management fee has been in a corridor of 24 to 25 for -- what's the answer, Phil -- 10 years? 15 years?

Yes, certainly since 97 or 98, it has been in that corridor.

I mean, should we -- I have been thinking that that was the corridor we were going to be living in -- kind of going up and down between that. Has your outlook on that corridor changed? Or should we be -- should that kind of what we as investors be thinking, given the fact that surplus is up, given the fact that the rating is where it is? Is that still the most likely corridor that we should be thinking about?

You are defining the corridor as --?

24 to 25.

24 to 25? I think that's too narrow of a definition. Obviously, we can't go above 25. And so -- but as I mentioned earlier, those are the type of discussions that we focus on, and this time of year, we're working towards that discussion at our December board meeting.

Great. Thank you. I guess we will hear more then.

Yes.

Ladies and gentlemen, we have reached the end of the allotted time for questions. Your final question comes from James Penn (ph) of CPE Partners.

Hi, guys. Just a big picture question. Your combined ratio ex. Isabel looks pretty good at 98.5. What do you think you can -- in terms of policy counts or number of policies out there -- what do you think your growth will be if you can -- while maintaining around a 100 combined ratio?

You're talking about 2004 then?

2004 -- you know, 2004, 2005.

We have given you some guidance in the Q and today of around what our average premium is going to be for 2004, which just from -- we've spoken to you about just from the rating increases, it's 9 to 10. And then on top of that, you always have to bake in the auto book (indiscernible) creep (ph), in the homeowners book -- you know, the inflation adjustments we make to policies and in commercial, things like payrolls increasing, which always adds 2 to 2.5 points. So, when you think about 2004, you have got to think that about 12 percent an average rate is already -- which we've told about. And we -- (Multiple Speakers)

Yes, I wasn't asking about average rate. I was asking about policy counts. I mean, that's ultimately what the real value of your company is -- is defined by the number of policies you have out there that is profitable and generating invested assets. I'm kind of curious -- I mean, you know, your rates will go up as a function of the market. But how many policy counts do you think you can -- what will the effect of having disciplined on the underwriting part do to your policy count, is the question?

Well, as you've seen, we've gone from twelve eight to twelve four to eleven. I'm talking about sequential, year-over-year policy count growth. Gone from twelve eight to twelve four to eleven to nine, here in the third quarter. And so what you're seeing is a year-over-year decline in that number. And it's going to continue to decline. We don't give guidance as to where it's going to end up for the year or even next year. But -- because it's subject to a lot of factors, including what we decide to do with the agency plan and new state (ph). So, those things are still in the air. They are still in our planning cycle with respect to those things. So, we don't give guidance on that. What we do give you is our line-of-business, year-over-year growth rates.

Is there a management goal in terms of -- is any part of your compensation based on the policy counts?

It's based on -- there are components of our compensation at the executive level -- senior management level -- that are based on premium growth, yes.

And just another question -- in terms of your expenses -- I believe your G&A expenses were up, what? -- 15 or 16 percent? -- slightly higher than your premium revenue growth. How long will that continue and what is that attributed to? You would think that you would get leverage at some point.

Our expenses at the cost of management operations, other than commissions, was up fourteen five, I believe. So it was a little less than premium growth. But, as I explained, in there were some -- first of all, 10.8 percent increase in personnel costs. And, again, we're going through our planning processes for this year. We understand our unit growth is dropping, and so we what we need to do as a management team is understand that and adjust our increases in personnel for 2004 and beyond. And then I also explained that our employee benefit costs, in terms of both our health plan, which we self-insure, and we had some adverse experience in that in the quarter -- higher utilization rates and some shock losses. And then discontinued -- we have a defined benefit plan, and the defined benefit plan is being whipsawed this year by the fact that the discount rate assumption we are using is much lower and the rate of return on assets is much lower. So vis-à-vis last year, we have a much higher expense coming through the books.

Do you expect that ratio to continue at that rate?

No, we have not finished our planning process. But we think we can keep the non-commission expenses in the high-single digits next year.

Well, where's the leverage? I don't understand where all this inflation is coming from. I can see where the inflation is coming from on your revenue side -- that's the premium -- that's the premium inflation that we are seeing in the hard (ph) market. But why are we -- why are expenses going up the same amount?

Well, they aren't. We continue to get productivity increases from our employment -- from our employees, in terms of policies enforced per employee. So our expenses went up 12 percent. Our non-commission expenses went up 12 percent year-to-date. And obviously, our premiums growing much faster than that. So they aren't equal. They aren't moving as fast, and we have some non-recurring items in the expenses. This pension thing is a big thing this year. So, again, we're focused on it. We are planning for 2004. We realize our policy and unit growth is going to slow in 2004 -- continues to slow in 2003. And so we're taking that into account as a management team. And we're focused on it.

Right. Now is the policy -- the slowing of policy growth, is that coming from not entering new states like Minnesota or slowing that development? Or is it coming from losing market share in Pennsylvania and Maryland -- states that we are usually strong in?

Well, first of all, when you enter a new state, the year you enter, it hardly has any effect. It takes 2 to 3 to 4 to 5 years for really that to have any effect at all on our growth. The same with appointing new agents. Appointing new agents this year or next year, they really don't get productive until the second or third year, so we're benefiting now from having gone into Illinois and Wisconsin because those states are hitting their stride.

Okay.

Because that really doesn't have a big effect.

Okay. Thank you.

Thank you everyone for joining us today on the call. That concludes our remarks. If you have any questions, please call me -- 814-870-4665. As I told you earlier, the recording will be posted on our website erieinsurance.com after 11:30 today. Thanks so much, and have a great day.

This concludes today's conference call. You may now disconnect.