Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion of financial condition and results of operations highlights significant factors influencing Erie Indemnity Company ("Indemnity", "we", "us", "our"). This discussion should be read in conjunction with the historical financial statements and the related notes thereto included in Part I, Item 1. "Financial Statements" of this Quarterly Report on Form 10-Q, and with Item 7. "Management’s Discussion and Analysis of Financial Condition and Results of Operations" for the year ended December 31, 2020, as contained in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on February 25, 2021.

INDEX

			Page Number
Cautionary Statement Regarding Forward-Looking Information			24
Operating Overview			25
Results of Operations			28
Financial Condition			34
Liquidity and Capital Resources			36
Critical Accounting Estimates			38

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION

"Safe Harbor" Statement under the Private Securities Litigation Reform Act of 1995:

Statements contained herein that are not historical fact are forward-looking statements and, as such, are subject to risks and uncertainties that could cause actual events and results to differ, perhaps materially, from those discussed herein. Forward-looking statements relate to future trends, events or results and include, without limitation, statements and assumptions on which such statements are based that are related to our plans, strategies, objectives, expectations, intentions, and adequacy of resources. Examples of forward-looking statements are discussions relating to premium and investment income, expenses, operating results, and compliance with contractual and regulatory requirements. Forward-looking statements are not guarantees of future performance and involve risks and uncertainties that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in such forward-looking statements. Among the risks and uncertainties, in addition to those set forth in our filings with the Securities and Exchange Commission, that could cause actual results and future events to differ from those set forth or contemplated in the forward-looking statements include the following:

• dependence upon our relationship with the Erie Insurance Exchange ("Exchange") and the management fee under the agreement with the subscribers at the Exchange;

• dependence upon our relationship with the Exchange and the growth of the Exchange, including:

◦general business and economic conditions;

◦factors affecting insurance industry competition;

◦dependence upon the independent agency system; and

◦ability to maintain our reputation for customer service;

• dependence upon our relationship with the Exchange and the financial condition of the Exchange, including:

◦the Exchange's ability to maintain acceptable financial strength ratings;

◦factors affecting the quality and liquidity of the Exchange's investment portfolio;

◦changes in government regulation of the insurance industry;

◦litigation and regulatory actions;

◦emerging claims and coverage issues in the industry; and

◦severe weather conditions or other catastrophic losses, including terrorism;

• potential impacts of the COVID-19 pandemic on the growth and financial condition of the Exchange;

• costs of providing policy issuance and renewal services to the Exchange under the subscriber's agreement;

• ability to attract and retain talented management and employees;

• ability to ensure system availability and effectively manage technology initiatives;

• difficulties with technology or data security breaches, including cyber attacks;

• ability to maintain uninterrupted business operations;

• outcome of pending and potential litigation;

• potential impacts of the COVID-19 pandemic on our operations, the business operations of our customers and/or independent agents, or our third-party vendor operations;

• factors affecting the quality and liquidity of our investment portfolio; and

• our ability to meet liquidity needs and access capital.

A forward-looking statement speaks only as of the date on which it is made and reflects our analysis only as of that date. We undertake no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events, changes in assumptions, or otherwise.

OPERATING OVERVIEW

Overview

We serve as the attorney-in-fact for the subscribers (policyholders) at the Exchange, a reciprocal insurer that writes property and casualty insurance. Our primary function as attorney-in-fact is to perform policy issuance and renewal services on behalf of the subscribers at the Exchange. We also act as attorney-in-fact on behalf of the Exchange, as well as the service provider for its insurance subsidiaries, with respect to all administrative services.

The Exchange is a reciprocal insurance exchange, which is an unincorporated association of individuals, partnerships and corporations that agree to insure one another. Each applicant for insurance to the Exchange signs a subscriber's agreement, which contains an appointment of Indemnity as their attorney-in-fact to transact the business of the Exchange on their behalf. Pursuant to the subscriber’s agreement for acting as attorney-in-fact in these two capacities, we earn a management fee calculated as a percentage of the direct and affiliated assumed premiums written by the Exchange.

Our earnings are primarily driven by the management fee revenue generated for the services we provide to the Exchange. The policy issuance and renewal services we provide to the Exchange are related to the sales, underwriting and issuance of policies. The sales related services we provide include agent compensation and certain sales and advertising support services. Agent compensation includes scheduled commissions to agents based upon premiums written as well as additional commissions and bonuses to agents, which are earned by achieving targeted measures. Agent compensation generally comprises approximately two-thirds of our policy issuance and renewal expenses. The underwriting services we provide include underwriting and policy processing. The remaining services we provide include customer service and administrative support. We also provide information technology services that support all the functions listed above. Included in these expenses are allocations of costs for departments that support these policy issuance and renewal functions.

By virtue of its legal structure as a reciprocal insurer, the Exchange does not have any employees or officers. Therefore, it enters into contractual relationships by and through an attorney-in-fact. Indemnity serves as the attorney-in-fact on behalf of the Exchange with respect to its administrative services. The Exchange's insurance subsidiaries also utilize Indemnity for these services in accordance with the service agreements between each of the subsidiaries and Indemnity. Claims handling services include costs incurred in the claims process, including the adjustment, investigation, defense, recording and payment functions. Life insurance management services include costs incurred in the management and processing of life insurance business. Investment management services are related to investment trading activity, accounting and all other functions attributable to the investment of funds. Included in these expenses are allocations of costs for departments that support these administrative functions. The amounts incurred for these services are reimbursed to Indemnity at cost in accordance with the subscriber's agreement and the service agreements. State insurance regulations require that intercompany service agreements and any material amendments be approved in advance by the state insurance department.

Our results of operations are tied to the growth and financial condition of the Exchange as the Exchange is our sole customer, and our earnings are largely generated from management fees based on the direct and affiliated assumed premiums written by the Exchange. The Exchange generates revenue by insuring preferred and standard risks, with personal lines comprising 71% of the 2020 direct and affiliated assumed written premiums and commercial lines comprising the remaining 29%. The principal personal lines products are private passenger automobile and homeowners. The principal commercial lines products are commercial multi-peril, commercial automobile and workers compensation.

Coronavirus ("COVID-19") pandemic

In March 2020, the outbreak of the coronavirus ("COVID-19") was declared a global pandemic. The uncertainty resulting from the COVID-19 pandemic continues to evolve and the pandemic’s ultimate impact and duration remain uncertain at this time.

The impact the COVID-19 pandemic has on the premiums written by the Exchange, our sole customer, affects our management fee revenue. The uncertainty of the ongoing impacts of the COVID-19 pandemic will likely continue until such time as the spread of the virus is contained. In response to reduced driving conditions in 2020 resulting from the COVID-19 pandemic, the Exchange implemented $200 million in personal and commercial auto rate reductions on policies written between July 1, 2020 and June 30, 2021. For the nine months ended September 30, 2021, these rate reductions resulted in a decrease to Exchange's written premiums of approximately $110 million and a corresponding decrease in our management fee revenue of approximately $28 million. There may also be other market and/or regulatory pressures that could impact the Exchange’s operations. While financial markets remained generally strong in the first nine months of 2021, we could experience future losses and/or impairments to the portfolio if future development of the pandemic impacts market conditions. Additionally, we continued to incur increased agent incentive costs as claim frequency, while increasing in 2021, remains lower than pre-pandemic levels resulting in improved agent profitability the first nine months of 2021. We have provided additional disclosure of these impacted areas throughout our Management’s Discussion and Analysis that follows. A broader discussion of the potential future impacts has also been disclosed in Financial Condition and Liquidity and Capital Resources contained within this report, as well as Part I. Item 1A. "Risk Factors" related to COVID-19 as included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2020 as filed with the Securities and Exchange Commission on February 25, 2021.

We have a dedicated internal committee comprised of management from various finance disciplines reviewing our risk positions and emerging trends on an ongoing basis as circumstances are evolving. The committee is reviewing risk scenarios and performing stress tests, including the review of cash flow trends, liquidity requirements and other forms of risk quantification. This provides tools for management, as well as our Risk Committee of the Board of Directors, to assess risks and prioritize key issues.

While we were not required to close our physical locations under the state mandated closure of nonessential services, out of concern for the health and safety of our employees, over 90% of our workforce has been working remote since March 2020. We have had no significant interruption to our core business processes or systems to date. We have had no significant changes to our financial close or reporting processes or related internal controls, nor do we anticipate any significant future challenges at this time. We have a dedicated team responsible for the development and implementation of a return to office plan. We began returning some employees to our offices in July 2021, but paused as a result of the national increase in infections. We plan to resume returning employees to our offices in phases when we consider it appropriate.

Financial Overview

						Three months ended September 30,																					Nine months ended September 30,
(dollars in thousands, except per share data)						2021						2020						% Change									2021						2020						% Change
						(Unaudited)																					(Unaudited)
Operating income						$	95,103					$	96,225					(1.2)			%						$	256,263					$	273,105					(6.2)			%
Total investment income						20,598						16,438						25.3									55,004						18,796						NM
Interest expense, net						1,034						3						NM									3,082						8						NM
Other expense						541						964						(43.7)									1,608						1,588						1.3
Income before income taxes						114,126						111,696						2.2									306,577						290,305						5.6
Income tax expense						23,903						22,480						6.3									63,759						59,786						6.6
Net income						$	90,223					$	89,216					1.1			%						$	242,818					$	230,519					5.3			%
Net income per share – diluted						$	1.72					$	1.71					1.1			%						$	4.64					$	4.41					5.3			%

NM = not meaningful

Operating income decreased in both the third quarter and nine months ended September 30, 2021, compared to the same periods in 2020, as growth in operating expenses outpaced the growth in operating revenues. Management fee revenue for policy issuance and renewal services increased 4.2% to $504.9 million in the third quarter of 2021 and 3.6% to $1.5 billion for the nine months ended September 30, 2021, respectively. Management fee revenue is based upon the management fee rate we charge, and the direct and affiliated assumed premiums written by the Exchange. The management fee rate was 25% for both 2021 and 2020. The direct and affiliated assumed premiums written by the Exchange increased 3.8% to $2.1 billion in the third quarter of 2021 and increased 3.0% to $6.0 billion for the nine months ended September 30, 2021 compared to the same periods in 2020.

Cost of operations for policy issuance and renewal services increased 5.1% to $430.3 million and 5.5% to $1.3 billion in the third quarter and nine months ended September 30, 2021, compared to the same periods in 2020, due to higher commissions driven by direct and affiliated assumed written premium growth, technology investments and personnel costs.

Management fee revenue for administrative services decreased 2.9% to $14.5 million and 1.1% to $44.0 million in the third quarter and nine months ended September 30, 2021, compared to the same periods in 2020. The administrative services reimbursement revenue and corresponding cost of operations increased both total operating revenue and total operating expenses by $162.4 million in the third quarter of 2021 and $473.1 million for the nine months ended September 30, 2021, but had no net impact on operating income.

Total investment income increased $4.2 million and $36.2 million in the third quarter and nine months ended September 30, 2021, compared to the same periods in 2020. The results from both periods were primarily due to increases in net investment income which were driven by favorable results in our limited partnership portfolio.

General Conditions and Trends Affecting Our Business

Economic conditions

Unfavorable changes in economic conditions, including declining consumer confidence, inflation, high unemployment, and the threat of recession, among others, may lead the Exchange’s customers to modify coverage, not renew policies, or even cancel policies, which could adversely affect the premium revenue of the Exchange, and consequently our management fee. As the COVID-19 pandemic continues to evolve, the extent and duration of the impacts to economic conditions remain uncertain. See Financial Condition and Liquidity and Capital Resources contained within this report, as well as Part I. Item 1A. "Risk Factors" related to COVID-19 included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2020 as filed with the Securities and Exchange Commission on February 25, 2021 for a discussion of the potential impacts of the COVID-19 pandemic on our operations.

Financial market volatility

Our portfolio of fixed maturity and equity security investments is subject to market volatility especially in periods of instability in the worldwide financial markets. Over time, net investment income could also be impacted by volatility and by the general level of interest rates, which impact reinvested cash flow from the portfolio and business operations. Depending upon market conditions, which are unpredictable and remain uncertain, considerable fluctuation could exist in the fair value of our investment portfolio and reported total investment income, which could have an adverse impact on our financial condition, results of operations, and cash flows. Significant volatility was seen in the global financial markets at the onset of the COVID-19 pandemic and pandemic related events may create future volatility. The extent of the impact on our invested assets cannot be estimated with a high degree of certainty at this time given the ongoing developments of this pandemic and the related impacts on the financial markets.

RESULTS OF OPERATIONS

Management fee revenue

We have two performance obligations in the subscriber’s agreement, providing policy issuance and renewal services and acting as attorney-in-fact for the Exchange, as well as the service provider for its insurance subsidiaries, with respect to all administrative services. We earn management fees for acting as the attorney-in-fact for the subscribers at the Exchange in these two capacities, and allocate our revenues between our performance obligations.

The management fee is calculated by multiplying all direct and affiliated assumed premiums written by the Exchange by the management fee rate, which is determined by our Board of Directors at least annually. The management fee rate was set at 25%, the maximum rate, for both 2021 and 2020. Changes in the management fee rate can affect our revenue and net income significantly. The transaction price, including management fee revenue and administrative service reimbursement revenue, includes variable consideration and is allocated based on the estimated standalone selling prices developed using industry information and other available information for similar services. We update the transaction price and the related allocation at least annually based upon the most recent information available or more frequently if there have been significant changes in any components considered in the transaction price. Our current transaction price allocation review resulted in a minor change in the allocation percentages between the two performance obligations. The change in allocation will not have a material impact on our financial statements.

The following table presents the allocation and disaggregation of revenue for our two performance obligations:

			Three months ended September 30,															Nine months ended September 30,
(dollars in thousands)			2021			2020			% Change									2021			2020			% Change
			(Unaudited)															(Unaudited)
Policy issuance and renewal services
Direct and affiliated assumed premiums written by the Exchange			$	2,075,745		$	1,999,074		3.8			%						$	6,024,484		$	5,849,505		3.0			%
Management fee rate			24.3		%	24.2		%										24.3		%	24.2		%
Management fee revenue			504,406			483,776			4.3									1,463,950			1,415,580			3.4
Change in estimate for management fee returned on cancelled policies (1)			485			775			(37.2)									(1,070)			(3,484)			69.3
Management fee revenue - policy issuance and renewal services			$	504,891		$	484,551		4.2			%						$	1,462,880		$	1,412,096		3.6			%
Administrative services
Direct and affiliated assumed premiums written by the Exchange			$	2,075,745		$	1,999,074		3.8			%						$	6,024,484		$	5,849,505		3.0			%
Management fee rate			0.7		%	0.8		%										0.7		%	0.8		%
Management fee revenue			14,530			15,993			(9.1)									42,171			46,796			(9.9)
Change in contract liability (2)			(67)			(1,064)			93.6									1,808			(2,247)			NM
Change in estimate for management fee returned on cancelled policies (1)			8			(19)			NM									6			(55)			NM
Management fee revenue - administrative services			14,471			14,910			(2.9)									43,985			44,494			(1.1)
Administrative services reimbursement revenue			162,410			147,710			10.0									473,133			451,229			4.9
Total revenue from administrative services			$	176,881		$	162,620		8.8			%						$	517,118		$	495,723		4.3			%

NM = not meaningful

*(1)*A constraining estimate of variable consideration exists related to the potential for management fees to be returned if a policy were to be cancelled mid-term. Management fees are returned to the Exchange when policies are cancelled mid-term and unearned premiums are refunded.

*(2)*Management fee revenue - administrative services is recognized over time as the services are provided. See Part I, Item 1. "Financial Statements - Note 3, Revenue, of Notes to Financial Statements" contained within this report.

Direct and affiliated assumed premiums written by the Exchange

Direct and affiliated assumed premiums include premiums written directly by the Exchange and premiums assumed from its wholly owned property and casualty subsidiaries. Direct and affiliated assumed premiums written by the Exchange increased 3.8% to $2.1 billion in the third quarter of 2021 compared to the third quarter of 2020, primarily driven by increases in homeowners and commercial multi-peril premiums written. Year-over-year policies in force for all lines of business increased 3.2% in the third quarter of 2021 compared to 1.7% in the third quarter of 2020. The year-over-year average premium per policy for all lines of business decreased 0.7% at September 30, 2021 compared to an increase of 0.8% at September 30, 2020. The year-over-year average premium per policy at September 30, 2021 was impacted by the rate reductions for our personal and commercial auto policies written between July 1, 2020 and June 30, 2021, in response to lower driving activity as a result of the COVID-19 pandemic.

Premiums generated from new business decreased 2.4% to $239 million in the third quarter of 2021. While year-over-year average premium per policy on new business increased 2.0% at September 30, 2021, new business policies written decreased 8.9% in the third quarter of 2021. Premiums generated from new business increased 10.4% to $244 million in the third quarter of 2020. While year-over-year average premium per policy on new business decreased 4.6% at September 30, 2020, new business policies written increased 19.7% in the third quarter of 2020. Premiums generated from renewal business increased 4.7% to $1.8 billion in the third quarter of 2021 compared to the third quarter of 2020. Underlying the trend in renewal business premiums was steady policy retention ratios, partially offset by a 1.0% decrease in year-over-year average premium per policy at September 30, 2021, compared to an increase of 1.5% at September 30, 2020.

Personal lines – Total personal lines premiums written increased 2.6% to $1.5 billion in the third quarter of 2021, compared to 1.8% in the third quarter of 2020. While total personal lines year-over-year average premium per policy decreased 1.5% at September 30, 2021, total personal lines policies in force increased 3.1% in the third quarter of 2021.

Commercial lines – Total commercial lines premiums written increased 7.2% to $582 million in the third quarter of 2021, compared to 2.5% in the third quarter of 2020, driven by a 3.7% increase in total commercial lines policies in force and a 0.9% increase in total commercial lines year-over-year average premium per policy.

Future trends-premium revenue – Through a careful agency selection process, the Exchange plans to continue its effort to expand the size of its agency force to increase market penetration in existing operating territories to contribute to future growth.

Changes in premium levels attributable to the growth in policies in force and rate changes directly affect the profitability of the Exchange and have a direct bearing on our management fee. Future premiums could be impacted by changes resulting from the COVID-19 pandemic, including potential regulatory changes and inflationary trends, among others. Longer-term, increased driving activity may result in future rate increases due to higher claims frequencies and severity. See also Part I. Item 1A. "Risk Factors" related to COVID-19 included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2020 as filed with the Securities and Exchange Commission on February 25, 2021.

Policy issuance and renewal services

			Three months ended September 30,															Nine months ended September 30,
(dollars in thousands)			2021			2020			% Change									2021			2020			% Change
			(Unaudited)															(Unaudited)
Management fee revenue - policy issuance and renewal services			$	504,891		$	484,551		4.2			%						$	1,462,880		$	1,412,096		3.6			%
Service agreement revenue			6,067			6,310			(3.9)									18,048			19,418			(7.1)
			510,958			490,861			4.1									1,480,928			1,431,514			3.5
Cost of policy issuance and renewal services			430,326			409,546			5.1									1,268,650			1,202,903			5.5
Operating income - policy issuance and renewal services			$	80,632		$	81,315		(0.8)			%						$	212,278		$	228,611		(7.1)			%

Policy issuance and renewal services

The management fee revenue allocated for providing policy issuance and renewal services was 24.3% and 24.2% of the direct and affiliated assumed premiums written by the Exchange for both the three and nine months ended September 30, 2021 and 2020, respectively. This portion of the management fee is recognized as revenue when the policy is issued or renewed because it is at that time that the services we provide are substantially complete and the executed insurance policy is transferred to the customer. The increase in management fee revenue for policy issuance and renewal services was driven by the increase in the direct and affiliated assumed premiums written by the Exchange discussed previously.

Service agreement revenue

Service agreement revenue includes service charges we collect from subscribers/policyholders for providing extended payment terms on policies written and assumed by the Exchange, and late payment and policy reinstatement fees. The service charges are fixed dollar amounts per billed installment. The decrease in service agreement revenue reflects the continued shift to payment plans that do not incur service charges or offer a premium discount for certain payment methods.

Cost of policy issuance and renewal services

			Three months ended September 30,															Nine months ended September 30,
(dollars in thousands)			2021			2020			% Change									2021			2020			% Change
			(Unaudited)															(Unaudited)
Commissions:
Total commissions			$	288,046		$	273,184		5.4			%						$	842,647		$	803,658		4.9			%
Non-commission expense:
Underwriting and policy processing			$	40,731		$	40,674		0.1			%						$	124,500		$	121,917		2.1			%
Information technology			46,693			42,940			8.7									139,174			128,253			8.5
Sales and advertising			13,422			12,111			10.8									38,955			39,356			(1.0)
Customer service			8,980			8,650			3.8									26,909			25,860			4.1
Administrative and other			32,454			31,987			1.5									96,465			83,859			15.0
Total non-commission expense			142,280			136,362			4.3									426,003			399,245			6.7
Total cost of policy issuance and renewal services			$	430,326		$	409,546		5.1			%						$	1,268,650		$	1,202,903		5.5			%

Commissions – Commissions increased $14.9 million in the third quarter of 2021 and $39.0 million for the nine months ended September 30, 2021 compared to the same periods in 2020, primarily driven by the growth in direct and affiliated assumed written premium, primarily in lines of business that pay a higher commission rate. To a lesser extent, there was also an increase in agent incentive compensation for the third quarter and nine months ended September 30, 2021 compared to the third quarter and nine months ending September 30, 2020. The estimated agent incentive payouts at September 30, 2021 are based on actual underwriting results for the two prior years and current year-to-date actual results and forecasted results for the remainder of 2021. For the nine months ended September 30, 2020, lower claims frequency and related loss expense due to the COVID-19 pandemic impacted agent compensation related to the profitability component.

Non-commission expense – Non-commission expense increased $5.9 million in the third quarter of 2021 compared to the third quarter of 2020. Information technology costs increased $3.8 million primarily due to increased hardware and software costs as well as increased personnel costs. Sales and advertising increased $1.3 million primarily due to personnel costs. Administrative and other costs increased $0.5 million primarily driven by increased building and equipment depreciation compared to the same period in 2020. Personnel costs in all expense categories for the third quarter of 2021 were impacted by higher medical costs compared to the prior year as the COVID-19 pandemic reduced elective procedures in 2020 and higher incentive plan award accruals due to increased direct written premium growth.

Non-commission expense increased $26.8 million in the nine months ended September 30, 2021 compared to the same period of 2020. Underwriting and policy processing expense increased $2.6 million primarily due to increased personnel costs and underwriting report costs. Information technology costs increased $10.9 million primarily due to increased hardware and software costs and personnel costs. Administrative and other costs increased $12.6 million primarily driven by increased building and equipment depreciation, professional fees and personnel costs compared to the same period in 2020. Personnel costs in all expense categories were impacted by higher medical costs compared to the prior year as the COVID-19 pandemic reduced elective procedures in 2020 and higher incentive plan award accruals due to increased direct written premium growth.

Administrative services

			Three months ended September 30,															Nine months ended September 30,
(dollars in thousands)			2021			2020			% Change									2021			2020			% Change
			(Unaudited)															(Unaudited)
Management fee revenue - administrative services			$	14,471		$	14,910		(2.9)			%						$	43,985		$	44,494		(1.1)			%
Administrative services reimbursement revenue			162,410			147,710			10.0									473,133			451,229			4.9
Total revenue allocated to administrative services			176,881			162,620			8.8									517,118			495,723			4.3
Administrative services expenses
Claims handling services			140,100			127,055			10.3									407,762			390,832			4.3
Investment management services			9,884			9,373			5.4									29,287			26,783			9.3
Life management services			12,426			11,282			10.1									36,084			33,614			7.3
Operating income - administrative services			$	14,471		$	14,910		(2.9)			%						$	43,985		$	44,494		(1.1)			%

Administrative services

The management fee revenue allocated to administrative services was 0.7% and 0.8% of the direct and affiliated assumed premiums written by the Exchange for both the three and nine months ended September 30, 2021 and 2020, respectively. This portion of the management fee is recognized as revenue over a four-year period representing the time over which the services are provided. We also report reimbursed costs as revenues, which are recognized monthly as services are provided. The administrative services expenses we incur and the related reimbursements we receive are recorded gross in the Statements of Operations.

Cost of administrative services

By virtue of its legal structure as a reciprocal insurer, the Exchange does not have any employees or officers. Therefore, it enters into contractual relationships by and through an attorney-in-fact. Indemnity serves as the attorney-in-fact on behalf of the Exchange with respect to its administrative services in accordance with the subscriber's agreement. The Exchange's insurance subsidiaries also utilize Indemnity for these services in accordance with the service agreements between each of the subsidiaries and Indemnity. The amounts incurred for these services are reimbursed to Indemnity at cost in accordance with the subscriber's agreement and the service agreements. We record these reimbursements due from the Exchange and its insurance subsidiaries as a receivable.

Total investment income

A summary of the results of our investment operations is as follows:

						Three months ended September 30,																		Nine months ended September 30,
(dollars in thousands)						2021			2020						% Change									2021						2020						% Change
						(Unaudited)																		(Unaudited)
Net investment income						$	18,858		$	10,645					77.2			%						$	49,605					$	20,353					NM
Net realized investment gains						1,610			5,915						(72.8)			%						5,183						1,635						NM
Net impairment recoveries (losses) recognized in earnings						130			(122)						NM									216						(3,192)						NM
Total investment income						$	20,598		$	16,438					25.3			%						$	55,004					$	18,796					NM

NM = not meaningful

Net investment income

Net investment income includes interest and dividends on our fixed maturity and equity security portfolios and the results of our limited partnership investments, net of investment expenses. Net investment income increased $8.2 million in the third quarter of 2021 and $29.3 million for the nine months ended September 30, 2021, compared to the same periods in 2020. The results from both periods were primarily due to equity in earnings of limited partnerships of $11.5 million and $26.7 million for the three and nine months ended September 30, 2021, respectively, compared to equity in earnings of limited partnerships of $3.6 million and equity in losses of limited partnerships $2.4 million, respectively, for the same periods in 2020. We have made no new limited partnership commitments since 2006, and the balance of limited partnership investments is expected to decline over time as additional distributions are received.

Net realized investment gains (losses)

A breakdown of our net realized investment gains (losses) is as follows:

						Three months ended September 30,												Nine months ended September 30,
(in thousands)						2021						2020						2021						2020
Securities sold:						(Unaudited)												(Unaudited)
Available-for-sale securities						$	2,189					$	137					$	4,069					$	1,107
Equity securities						(267)						1,796						5						(1,009)
Equity securities change in fair value						(312)						3,981						1,108						1,534
Miscellaneous						0						1						1						3
Net realized investment gains						$	1,610					$	5,915					$	5,183					$	1,635

Net realized gains during the three and nine months ended September 30, 2021 were primarily due to disposals of available-for-sale securities. Net realized gains during the three and nine months ended September 30, 2020 were primarily due to market value adjustments on equity securities.

Net impairment recoveries (losses) recognized in earnings

Net impairment recoveries during the three and nine months ended September 30, 2021 were primarily a result of the change in the current expected credit loss allowance related to our agent loans. Net impairment losses for the nine months ended September 30, 2020 were primarily due to the COVID-19 pandemic's impact on financial markets on our available-for-sale securities.

Financial condition of Erie Insurance Exchange

Serving in the capacity of attorney-in-fact for the Exchange, we are dependent on the growth and financial condition of the Exchange, who is our sole customer. The strength of the Exchange and its wholly owned subsidiaries is rated annually by A.M. Best Company through assessing its financial stability and ability to pay claims. The ratings are generally based upon factors relevant to policyholders and are not directed toward return to investors. The Exchange and each of its property and casualty subsidiaries are rated A+ "Superior", the second highest financial strength rating, which is assigned to companies that have achieved superior overall performance when compared to the standards established by A.M. Best and have a superior ability to meet obligations to policyholders over the long term. On July 27, 2021, the outlook for the financial strength rating was affirmed as stable. As of December 31, 2020, only approximately 12% of insurance groups, in which the Exchange is included, are rated A+ or higher.

The financial statements of the Exchange are prepared in accordance with statutory accounting principles prescribed by the Commonwealth of Pennsylvania. Financial statements prepared under statutory accounting principles focus on the solvency of the insurer and generally provide a more conservative approach than under U.S. generally accepted accounting principles. Statutory direct written premiums of the Exchange and its wholly owned property and casualty subsidiaries grew 3.0% to $6.0 billion in the first nine months of 2021 compared to the first nine months of 2020. These premiums, along with investment income, are the major sources of cash that support the operations of the Exchange. Policyholders’ surplus determined under statutory accounting principles was $11.7 billion at September 30, 2021, $10.7 billion at December 31, 2020, and $10.0 billion at September 30, 2020. The Exchange and its wholly owned property and casualty subsidiaries' year-over-year policy retention ratio continues to be high at 90.0% at September 30, 2021 and 89.9% at both December 31, 2020 and September 30, 2020.

We have prepared our financial statements considering the financial strength of the Exchange based on its A.M. Best rating and strong level of surplus. We are monitoring risks related to the COVID-19 pandemic on an ongoing basis and believe that the Exchange falls within defined risk tolerances. However, see Part I. Item 1A. "Risk Factors" related to COVID-19 included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2020 as filed with the Securities and Exchange Commission on February 25, 2021 for possible outcomes that could impact that determination.

FINANCIAL CONDITION

Investments

Our investment portfolio is managed with the objective of maximizing after-tax returns on a risk-adjusted basis. The following table presents the carrying value of our investments as of:

(dollars in thousands)						September 30, 2021						% to total						December 31, 2020						% to total
						(Unaudited)
Fixed maturities						$	937,504					83		%				$	928,236					84		%
Equity securities:
Preferred stock						86,270						8						94,071						9
Common stock						10						0						19						0
Agent loans (1)						67,789						6						69,212						6
Other investments						40,009						3						14,325						1
Total investments						$	1,131,582					100		%				$	1,105,863					100		%

*(1)*The current portion of agent loans is included with prepaid expenses and other current assets in the Statements of Financial Position.

Fixed maturities

Under our investment strategy, we maintain a fixed maturity portfolio that is of high quality and well diversified within each market sector. This investment strategy also achieves a balanced maturity schedule. Our fixed maturity portfolio is managed with the goal of achieving reasonable returns while limiting exposure to risk.

Fixed maturities are carried at fair value with unrealized gains and losses, net of deferred taxes, included in shareholders’ equity. Net unrealized gains on fixed maturities, net of deferred taxes, totaled $13.5 million at September 30, 2021, compared to net unrealized gains of $23.3 million at December 31, 2020.

The following table presents a breakdown of the fair value of our fixed maturity portfolio by industry sector and rating as of:

(in thousands)						September 30, 2021 (1)
						AAA						AA						A						BBB						Non- investment grade						Fair value
						(Unaudited)
Basic materials						$	0					$	0					$	3,206					$	0					$	8,930					$	12,136
Communications						0						8,742						8,456						17,550						18,715						53,463
Consumer						0						3,180						20,079						69,040						42,643						134,942
Diversified						0						0						0						1,033						1,004						2,037
Energy						0						4,160						7,835						18,554						11,863						42,412
Financial						0						1,015						67,054						113,215						16,850						198,134
Industrial						0						0						10,009						16,435						24,128						50,572
Structured securities (2)						151,952						164,822						30,168						16,846						0						363,788
Technology						5,213						0						7,814						22,137						13,317						48,481
U.S. Treasury						0						5,749						0						0						0						5,749
Utilities						0						0						3,800						17,045						4,945						25,790
Total						$	157,165					$	187,668					$	158,421					$	291,855					$	142,395					$	937,504

*(1)*Ratings are supplied by S&P, Moody’s, and Fitch. The table is based upon the lowest rating for each security.

*(2)*Structured securities include residential and commercial mortgage-backed securities, collateralized debt obligations, and asset-backed securities.

Equity securities

Equity securities consist of nonredeemable preferred and common stock and are carried at fair value in the Statements of Financial Position with all changes in unrealized gains and losses reflected in the Statements of Operations.

The following table presents an analysis of the fair value of our nonredeemable preferred and common stock securities by sector as of:

(in thousands)						September 30, 2021												December 31, 2020
						Preferred stock						Common stock						Preferred stock						Common stock
						(Unaudited)
Communications						$	1,013					$	0					$	2,699					$	0
Consumer						2,218						0						3,068						0
Energy						5,306						10						2,187						19
Financial services						70,432						0						76,575						0
Industrial						255						0						800						0
Utilities						7,046						0						8,742						0
Total						$	86,270					$	10					$	94,071					$	19

LIQUIDITY AND CAPITAL RESOURCES

We continue to monitor the sufficiency of our liquidity and capital resources given the potential impact of the COVID-19 pandemic. We did not see a significant impact on our sources or uses of cash in the first nine months of 2021. However, we may experience future reductions in our management fee revenue if the Exchange’s premium growth is constrained. Also, future disruptions in the markets could occur which may affect our liquidity position. If our normal operating and investing cash activities were to become insufficient to meet future funding requirements, we believe we have sufficient access to liquidity through our cash position, liquid marketable securities and our $100 million line of credit that does not expire until October 2023. See broader discussions of potential risks to our operations in the Operating Overview contained within this report and Part I. Item 1A. "Risk Factors" related to COVID-19 included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2020 as filed with the Securities and Exchange Commission on February 25, 2021.

Sources and Uses of Cash

Liquidity is a measure of a company’s ability to generate sufficient cash flows to meet the short- and long-term cash requirements of its business operations and growth needs. Our liquidity requirements have been met primarily by funds generated from management fee revenue and income from investments. Cash provided from these sources is used primarily to fund the costs of our management operations including commissions, salaries and wages, pension plans, share repurchases, dividends to shareholders, and the purchase and development of information technology. We expect that our operating cash needs will be met by funds generated from operations.

Volatility in the financial markets presents challenges to us as we do occasionally access our investment portfolio as a source of cash. Some of our fixed income investments, despite being publicly traded, may be illiquid. Volatility in these markets could impair our ability to sell certain fixed income securities or cause such securities to sell at deep discounts. We believe we have sufficient liquidity to meet our needs from sources other than the liquidation of securities, even if market volatility persists throughout 2021 and beyond.

Cash flow activities

The following table provides condensed cash flow information for the nine months ended September 30:

(in thousands)						2021						2020
						(Unaudited)						(Unaudited)
Net cash provided by operating activities						$	264,038					$	234,478
Net cash used in investing activities						(43,158)						(218,571)
Net cash used in financing activities						(146,124)						(136,291)
Net increase (decrease) in cash and cash equivalents						$	74,756					$	(120,384)

Net cash provided by operating activities was $264.0 million in the first nine months of 2021, compared to $234.5 million in the first nine months of 2020. Increased cash provided by operating activities in the first nine months of 2021 was primarily due to an increase in management fees received driven by growth in direct and affiliated assumed premiums written by the Exchange of $62.3 million and an increase in administrative service reimbursements received of $39.3 million. Partially offsetting the increase in cash provided by operating activities was an increase in cash paid for agent commissions of $30.0 million, due to higher scheduled commission driven by premium growth, an increase in agent bonuses of $15.5 million and increases in administrative services expenses paid of $31.0 million, in the first nine months of 2021 compared to the same period in 2020.

Net cash used in investing activities was $43.2 million in the first nine months of 2021, compared to $218.6 million in the same period in 2020. In the first nine months of 2021, net cash used in investing activities was primarily driven by fixed asset purchases, as purchases of investments were offset by proceeds from sales and maturities/calls of investments. Net cash used in investing activities in the first nine months of 2020 was primarily due to purchases of available-for-sale securities exceeding the proceeds generated from investment sales and maturities/calls of available-for-sale securities.

Net cash used in financing activities totaled $146.1 million in the first nine months of 2021, compared to $136.3 million in the first nine months of 2020. The increase in cash used in the first nine months of 2021, compared to the same period in 2020, was due to dividends paid to shareholders. We increased both our Class A and Class B shareholder regular quarterly dividends by 7.3% for 2021, compared to 2020. There are no regulatory restrictions on the payment of dividends to our shareholders.

There were no repurchases of our Class A nonvoting common stock in the first nine months of 2021 and 2020 in conjunction with our stock repurchase program. In 2011, our Board of Directors approved a continuation of the current stock repurchase program of $150 million with no time limitation. This repurchase authority includes, and is not in addition to, any unspent amounts remaining under the prior authorization. We had approximately $17.8 million of repurchase authority remaining under this program at September 30, 2021, based upon trade date.

During the nine months ended September 30, 2021, we purchased 25,065 shares of our outstanding Class A nonvoting common stock outside of our publicly announced share repurchase program at a total cost of $5.0 million. Of this amount, we purchased 978 shares for $0.2 million, or $242.01 per share, for stock-based awards in conjunction with our equity compensation plan. We purchased 3,939 shares for $0.8 million, or $212.69 per share, to fund the rabbi trust for the outside director deferred stock compensation plan. The remaining 20,148 shares were purchased at a total cost of $4.0 million, or $196.25 per share, to fund the rabbi trust for the incentive compensation deferral plan. All shares were delivered as of September 30, 2021.

During the nine months ended September 30, 2020, we purchased 28,155 shares of our outstanding Class A nonvoting common stock outside of our publicly announced share repurchase program at a total cost of $5.0 million. Of this amount, we purchased 1,787 shares for $0.3 million, or $165.82 per share, for stock-based awards in conjunction with our equity compensation plan. We purchased 4,785 shares for $0.9 million, or $178.98 per share, to fund the rabbi trust for the outside director deferred stock compensation plan. The remaining 21,583 shares were purchased at a total cost of $3.8 million, or $178.62 per share, to fund the rabbi trust for the incentive compensation deferral plan. All shares were delivered as of September 30, 2020.

Capital Outlook

We regularly prepare forecasts evaluating the current and future cash requirements for both normal and extreme risk events, including the current COVID-19 pandemic. Should an extreme risk event result in a cash requirement exceeding normal cash flows, we have the ability to meet our future funding requirements through various alternatives available to us.

Outside of our normal operating and investing cash activities, future funding requirements could be met through: 1) cash and cash equivalents, which total approximately $236.0 million at September 30, 2021, 2) a $100 million bank revolving line of credit, and 3) liquidation of unpledged assets held in our investment portfolio, including preferred stock and investment grade bonds, which totaled approximately $644.2 million at September 30, 2021. Volatility in the financial markets could impair our ability to sell certain fixed income securities or cause such securities to sell at deep discounts. Additionally, we have the ability to curtail or modify discretionary cash outlays such as those related to shareholder dividends and share repurchase activities.

As of September 30, 2021, we have access to a $100 million bank revolving line of credit with a $25 million letter of credit sublimit that expires on October 30, 2023. As of September 30, 2021, a total of $99.1 million remains available under the facility due to $0.9 million outstanding letters of credit, which reduce the availability for letters of credit to $24.1 million. We had no borrowings outstanding on our line of credit as of September 30, 2021. Investments with a fair value of $122.6 million were pledged as collateral on the line at September 30, 2021. The investments pledged as collateral have no trading restrictions and are reported as available-for-sale securities and cash and cash equivalents in the Statements of Financial Position. The banks require compliance with certain covenants, which include leverage ratios and debt restrictions. We were in compliance with our bank covenants at September 30, 2021.

Off-Balance Sheet Arrangements and Contractual Obligations

Off-balance sheet arrangements include those with unconsolidated entities that may have a material current or future effect on our financial condition or results of operations, including material variable interests in unconsolidated entities that conduct certain activities. We have no material off-balance sheet obligations. As of September 30, 2021, there were no material changes to our future contractual obligations as previously reported in our Annual Report on Form 10-K for the fiscal year ended December 31, 2020 as filed with the Securities and Exchange Commission on February 25, 2021.

CRITICAL ACCOUNTING ESTIMATES

We make estimates and assumptions that have a significant effect on the amounts and disclosures reported in the financial statements. The most significant estimates relate to investment valuation and retirement benefit plans for employees. While management believes its estimates are appropriate, the ultimate amounts may differ from estimates provided. Our most critical accounting estimates are described in Item 7. "Management’s Discussion and Analysis of Financial Condition and Results of Operations" for the year ended December 31, 2020 of our Annual Report on Form 10-K as filed with the Securities and Exchange Commission on February 25, 2021. See Part I, Item 1. "Financial Statements - Note 5, Fair Value, of Notes to Financial Statements" contained within this report for additional information on our valuation of investments.