Edgar Filing: ERIE INDEMNITY CO

10-Q

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2016

Commission file number 0-24000



	ERIE INDEMNITY COMPANY
	(Exact name of registrant as specified in its charter)



	PENNSYLVANIA		25-0466020
	(State or other jurisdiction of		(I.R.S. Employer
	incorporation or organization)		Identification No.)



	100 Erie Insurance Place, Erie, Pennsylvania		16530
	(Address of principal executive offices)		(Zip Code)



	(814) 870-2000
	(Registrant’s telephone number, including area code)



	Not applicable
	(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes X No ___

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes X No ___

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes X No ___

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large Accelerated Filer X Accelerated Filer ___ Non-Accelerated Filer ___ Smaller Reporting Company ___

(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes No X

The number of shares outstanding of the registrant’s Class A Common Stock as of the latest practicable date, with no par value and a stated value of $0.0292 per share, was 46,189,068 at April 15, 2016.

The number of shares outstanding of the registrant’s Class B Common Stock as of the latest practicable date, with no par value and a stated value of $70 per share, was 2,542 at April 15, 2016.

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PART I.	FINANCIAL INFORMATION

Item 1.	Financial Statements (Unaudited)

	Statements of Operations – Three months ended March 31, 2016 and 2015

	Statements of Comprehensive Income – Three months ended March 31, 2016 and 2015

	Statements of Financial Position – March 31, 2016 and December 31, 2015

	Statements of Cash Flows – Three months ended March 31, 2016 and 2015

	Notes to Financial Statements – March 31, 2016

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations

Item 3.	Quantitative and Qualitative Disclosures About Market Risk

Item 4.	Controls and Procedures


PART II.	OTHER INFORMATION

Item 1.	Legal Proceedings

Item 1A.	Risk Factors

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds

Item 6.	Exhibits


	SIGNATURES

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PART I. FINANCIAL INFORMATION


ITEM 1.	FINANCIAL STATEMENTS

ERIE INDEMNITY COMPANY

STATEMENTS OF OPERATIONS (UNAUDITED)

(dollars in thousands, except per share data)



	Three months ended
	March 31,
	2016			2015
Operating revenue
Management fee revenue, net	$	367,458		$	343,234
Service agreement revenue	7,270			7,597
Total operating revenue	374,728			350,831

Operating expenses
Commissions	208,714			193,717
Salaries and employee benefits	53,289			55,019
All other operating expenses	45,060			49,665
Total operating expenses	307,063			298,401
Net revenue from operations	67,665			52,430

Investment income
Net investment income	4,662			4,541
Net realized investment losses	(1,088		)	(240		)
Net impairment losses recognized in earnings	(345		)	(120		)
Equity in (losses) earnings of limited partnerships	(670		)	2,358
Total investment income	2,559			6,539
Income before income taxes	70,224			58,969
Income tax expense	24,329			20,136
Net income	$	45,895		$	38,833


Earnings Per Share
Net income per share
Class A common stock – basic	$	0.99		$	0.83
Class A common stock – diluted	$	0.87		$	0.74
Class B common stock – basic and diluted	$	148		$	125

Weighted average shares outstanding – Basic
Class A common stock	46,189,068			46,189,068
Class B common stock	2,542			2,542

Weighted average shares outstanding – Diluted
Class A common stock	52,523,927			52,634,752
Class B common stock	2,542			2,542

Dividends declared per share
Class A common stock	$	0.730		$	0.681
Class B common stock	$	109.500		$	102.150

See accompanying notes to Financial Statements. See Note 10, "Accumulated Other Comprehensive Income (Loss)", for amounts reclassified out of accumulated other comprehensive income (loss) into the Statements of Operations.

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ERIE INDEMNITY COMPANY

STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)

(in thousands)



	Three months ended
	March 31,
	2016		2015
Net income	$	45,895	$	38,833

Other comprehensive income, net of tax
Change in unrealized holding gains on available-for-sale securities	3,465		100

Comprehensive income	$	49,360	$	38,933

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ERIE INDEMNITY COMPANY

STATEMENTS OF FINANCIAL POSITION

(dollars in thousands, except per share data)



	March 31,			December 31,
	2016			2015
Assets	(Unaudited)
Current assets:
Cash and cash equivalents	$	105,282		$	182,889
Available-for-sale securities	54,285			62,067
Trading securities	2,955			—
Receivables from Erie Insurance Exchange and affiliates	352,451			348,055
Prepaid expenses and other current assets	37,164			24,697
Federal income taxes recoverable	0			11,947
Accrued investment income	5,832			5,491
Total current assets	557,969			635,146

Available-for-sale securities	560,928			537,874
Limited partnership investments	82,912			88,535
Fixed assets, net	58,918			59,087
Deferred income taxes, net	35,250			40,686
Note receivable from Erie Family Life Insurance Company	25,000			25,000
Other assets	19,647			20,968
Total assets	$	1,340,624		$	1,407,296

Liabilities and shareholders' equity
Current liabilities:
Commissions payable	$	202,816		$	195,542
Agent bonuses	31,940			106,752
Accounts payable and accrued liabilities	79,333			88,532
Dividends payable	33,996			33,996
Deferred executive compensation	15,132			20,877
Federal income taxes payable	8,541			0
Total current liabilities	371,758			445,699

Defined benefit pension plans	162,981			172,700
Employee benefit obligations	1,072			1,234
Deferred executive compensation	18,446			16,580
Other long-term liabilities	1,500			1,580
Total liabilities	555,757			637,793

Shareholders’ equity
Class A common stock, stated value $0.0292 per share; 74,996,930 shares authorized; 68,299,200 shares issued; 46,189,068 shares outstanding	1,992			1,992
Class B common stock, convertible at a rate of 2,400 Class A shares for one Class B share, stated value $70 per share; 3,070 shares authorized; 2,542 shares issued and outstanding	178			178
Additional paid-in-capital	16,311			16,311
Accumulated other comprehensive loss	(93,399		)	(96,864		)
Retained earnings	2,005,875			1,993,976
Total contributed capital and retained earnings	1,930,957			1,915,593
Treasury stock, at cost; 22,110,132 shares held	(1,155,108		)	(1,155,108		)
Deferred compensation	9,018			9,018
Total shareholders’ equity	784,867			769,503
Total liabilities and shareholders’ equity	$	1,340,624		$	1,407,296

See accompanying notes to Financial Statements.

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ERIE INDEMNITY COMPANY

STATEMENTS OF CASH FLOWS (UNAUDITED)

(in thousands)



	Three months ended
	March 31,
	2016			2015
Cash flows from operating activities
Management fee received	$	363,848		$	341,806
Service agreement fee received	7,270			7,597
Net investment income received	6,182			6,374
Limited partnership distributions	1,127			4,954
Decrease in reimbursements collected from affiliates	(785		)	(412		)
Commissions paid to agents	(172,625		)	(169,821		)
Agents bonuses paid	(103,933		)	(79,483		)
Salaries and wages paid	(45,732		)	(42,486		)
Pension contribution and employee benefits paid	(24,636		)	(22,056		)
General operating expenses paid	(52,220		)	(61,715		)
Income taxes paid	(258		)	(9		)
Net cash used in operating activities	(21,762		)	(15,251		)

Cash flows from investing activities
Purchase of investments:
Available-for-sale securities	(67,557		)	(30,725		)
Limited partnerships	(103		)	(89		)
Proceeds from investments:
Available-for-sale securities	46,507			37,554
Limited partnerships	1,792			9,157
Net purchase of fixed assets	(3,496		)	(2,428		)
Net collections (distributions) on agent loans	1,008			(644		)
Net cash (used in) provided by investing activities	(21,849		)	12,825

Cash flows from financing activities
Dividends paid to shareholders	(33,996		)	(31,714		)
Net cash used in financing activities	(33,996		)	(31,714		)

Net decrease in cash and cash equivalents	(77,607		)	(34,140		)
Cash and cash equivalents, beginning of period	182,889			91,747
Cash and cash equivalents, end of period	$	105,282		$	57,607

See accompanying notes to Financial Statements.

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NOTES TO FINANCIAL STATEMENTS (UNAUDITED)

Note 1. Nature of Operations

Erie Indemnity Company ("Indemnity", "we", "us", "our") is a publicly held Pennsylvania business corporation that has since its incorporation in 1925 served as the attorney-in-fact for the subscribers (policyholders) at the Erie Insurance Exchange ("Exchange"). The Exchange, which also commenced business in 1925, is a Pennsylvania-domiciled reciprocal insurer that writes property and casualty insurance. We function solely as the management company and all insurance operations are performed by the Exchange.

Our primary function, as attorney-in-fact, is to perform certain services for the Exchange relating to the sales, underwriting, and issuance of policies on behalf of the Exchange. This is done in accordance with a subscriber’s agreement (a limited power of attorney) executed individually by each subscriber (policyholder), which appoints us as their common attorney-in-fact to transact certain business on their behalf and to manage the affairs of the Exchange. Pursuant to the subscriber’s agreement and for its services as attorney-in-fact, we earn a management fee calculated as a percentage of the direct and assumed premiums written by the Exchange.

Our results of operations are tied to the growth and financial condition of the Exchange. If any events occurred that impaired the Exchange’s ability to grow or sustain its financial condition, including but not limited to reduced financial strength ratings, disruption in the independent agency relationships, significant catastrophe losses, or products not meeting customer demands, the Exchange could find it more difficult to retain its existing business and attract new business. A decline in the business of the Exchange almost certainly would have as a consequence a decline in the total premiums paid and a correspondingly adverse effect on the amount of the management fees we receive. We also have an exposure to a concentration of credit risk related to the unsecured receivables due from the Exchange for its management fee. See Note 11, "Concentrations of Credit Risk" contained within this report.

Note 2. Significant Accounting Policies

Basis of presentation

The accompanying unaudited financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP") for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three-month period ended March 31, 2016 are not necessarily indicative of the results that may be expected for the year ending December 31, 2016. For further information, refer to the financial statements and footnotes included in our Form 10-K for the year ended December 31, 2015 as filed with the Securities and Exchange Commission on February 25, 2016.

The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Certain prior period amounts have been reclassified on the statements of financial position to conform to the current period presentation. These reclassifications had no effect on the previously reported results of operations.

Recently issued accounting standards

In February 2015, the Financial Accounting Standards Board ("FASB") updated Accounting Standards Codification ("ASC") 810 "Consolidation", which amended the existing guidance for determining if a reporting entity has a variable interest in a legal entity. We adopted the new accounting principle on a retrospective basis as of December 31, 2015. In accordance with the new accounting guidance, Indemnity is not deemed to have a variable interest in the Exchange as the fees paid for services provided to the Exchange no longer represent a variable interest. The compensation received from the attorney-in-fact fee arrangement with the subscribers is for services provided by Indemnity acting in its role as attorney-in-fact and is commensurate with the level of effort required to perform those services. Under the previously issued accounting guidance, Indemnity was deemed to be the primary beneficiary of the Exchange and its financial position and operating results were consolidated with Indemnity. Following adoption of the new accounting guidance, the Exchange’s results are no longer required to be consolidated with Indemnity. There was no cumulative effect to Indemnity's shareholders’ equity or net income from no longer consolidating the Exchange's results with ours.

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In February 2016, the FASB issued Accounting Standards Update ("ASU") 2016-02, "Leases", which requires lessees to recognize assets and liabilities arising from operating leases on the statement of financial position and to disclose key information about leasing arrangements. ASU 2016-02 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. Early adoption is permitted. We are currently evaluating the potential impact of this guidance on our financial statements.

In January 2016, the FASB issued ASU 2016-01, "Financial Instruments-Overall". ASU 2016-01 revises the accounting related to the classification and measurement of investments in equity securities and the presentation of certain fair value changes for financial liabilities measured at fair value. ASU 2016-01 is effective for interim and annual reporting periods beginning after December 15, 2017. We are currently evaluating the potential impact of this guidance on our financial statements.

In May 2014, the FASB issued ASU 2014-09, "Revenue from Contracts with Customers". ASU 2014-09 requires an entity to recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance is effective for fiscal years beginning after December 15, 2017 including interim periods within that reporting period. We do not expect the adoption of this guidance to have a material impact on our financial statements.

Note 3. Earnings Per Share

Class A and Class B basic earnings per share and Class B diluted earnings per share are calculated under the two-class method. The two-class method allocates earnings to each class of stock based upon its dividend rights. Class B shares are convertible into Class A shares at a conversion ratio of 2,400 to 1. See Note 9, "Capital Stock".

Class A diluted earnings per share are calculated under the if-converted method, which reflects the conversion of Class B shares to Class A shares. Diluted earnings per share calculations include the dilutive effect of assumed issuance of stock-based awards under compensation plans that have the option to be paid in stock using the treasury stock method.

A reconciliation of the numerators and denominators used in the basic and diluted per-share computations is presented as follows for each class of common stock:



(dollars in thousands, except per share data)	Three months ended March 31,
	2016					2015
	Allocated net income (numerator)		Weighted shares (denominator)	Per-share amount		Allocated net income (numerator)		Weighted shares (denominator)	Per-share amount
Class A – Basic EPS:
Income available to Class A stockholders	$	45,520	46,189,068	$	0.99	$	38,515	46,189,068	$	0.83
Dilutive effect of stock-based awards	0		234,059	—		0		344,884	—
Assumed conversion of Class B shares	375		6,100,800	—		318		6,100,800	—
Class A – Diluted EPS:
Income available to Class A stockholders on Class A equivalent shares	$	45,895	52,523,927	$	0.87	$	38,833	52,634,752	$	0.74
Class B – Basic and diluted EPS:
Income available to Class B stockholders	$	375	2,542	$	148	$	318	2,542	$	125

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Note 4. Fair Value

Our available-for-sale and trading securities are recorded at fair value, which is the price that would be received to sell the asset in an orderly transaction between willing market participants as of the measurement date.

Valuation techniques used to derive the fair value of our available-for-sale and trading securities are based upon observable and unobservable inputs. Observable inputs reflect market data obtained from independent sources. Unobservable inputs reflect our own assumptions regarding fair market value for these securities. Although the majority of our prices are obtained from third party sources, we also perform an internal pricing review for securities with low trading volumes under current market conditions. Financial instruments are categorized based upon the following characteristics or inputs to the valuation techniques:


•	Level 1 – Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity can access at the measurement date.


•	Level 2 – Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.


•	Level 3 – Unobservable inputs for the asset or liability.

Estimates of fair values for our investment portfolio are obtained primarily from a nationally recognized pricing service. Our Level 1 category includes those securities valued using an exchange traded price provided by the pricing service. The methodologies used by the pricing service that support a Level 2 classification of a financial instrument include multiple verifiable, observable inputs including benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data. Pricing service valuations for Level 3 securities are based upon proprietary models and are used when observable inputs are not available or in illiquid markets.

In limited circumstances we adjust the price received from the pricing service when, in our judgment, a better reflection of fair value is available based upon corroborating information and our knowledge and monitoring of market conditions such as a disparity in price of comparable securities and/or non-binding broker quotes. In other circumstances, certain securities are internally priced because prices are not provided by the pricing service.

We perform continuous reviews of the prices obtained from the pricing service. This includes evaluating the methodology and inputs used by the pricing service to ensure that we determine the proper classification level of the financial instrument. Price variances, including large periodic changes, are investigated and corroborated by market data. We have reviewed the pricing methodologies of our pricing service as well as other observable inputs, such as data, and transaction volumes and believe that their prices adequately consider market activity in determining fair value. Our review process continues to evolve based upon accounting guidance and requirements.

When a price from the pricing service is not available, values are determined by obtaining broker/dealer quotes and/or market comparables. When available, we obtain multiple quotes for the same security. The ultimate value for these securities is determined based upon our best estimate of fair value using corroborating market information. Our evaluation includes the consideration of benchmark yields, reported trades, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data.

For certain securities in an illiquid market, there may be no prices available from a pricing service and no comparable market quotes available. In these situations, we value the security using an internally-developed, risk-adjusted discounted cash flow model.

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The following tables present our fair value measurements on a recurring basis by asset class and level of input:



	At March 31, 2016
	Fair value measurements using:
(in thousands)	Total		Quoted prices in active markets for identical assets Level 1		Observable inputs Level 2		Unobservable inputs Level 3
Available-for-sale securities:
States & political subdivisions	$	242,524	$	0	$	242,524	$	0
Corporate debt securities	256,498		0		251,677		4,821
Residential mortgage-backed securities	14,875		0		14,875		0
Commercial mortgage-backed securities	35,596		0		35,596		0
Collateralized debt obligations	54,770		0		42,733		12,037
Other debt securities	2,018		0		2,018		0
Total fixed maturities	606,281		0		589,423		16,858
Common stock	8,932		8,932		0		0
Total available-for-sale securities	615,213		8,932		589,423		16,858
Trading securities:
Common stock	2,955		2,955		0		0
Other investments ⁽¹⁾	4,302		—		—		—
Total	$	622,470	$	11,887	$	589,423	$	16,858



	At December 31, 2015
	Fair value measurements using:
(in thousands)	Total		Quoted prices in active markets for identical assets Level 1		Observable inputs Level 2		Unobservable inputs Level 3
Available-for-sale securities:
States & political subdivisions	$	231,847	$	0	$	231,847	$	0
Corporate debt securities	250,333		0		250,264		69
Residential mortgage-backed securities	13,513		0		13,513		0
Commercial mortgage-backed securities	37,571		0		37,571		0
Collateralized debt obligations	51,745		0		43,168		8,577
Other debt securities	2,200		0		2,200		0
Total fixed maturities	587,209		0		578,563		8,646
Common stock	12,732		12,732		0		0
Total available-for-sale securities	599,941		12,732		578,563		8,646
Other investments ⁽¹⁾	4,526		—		—		—
Total	$	604,467	$	12,732	$	578,563	$	8,646

(1) Other investments measured at fair value represent real estate funds included on the balance sheet as limited partnership investments that are reported under the fair value option using the net asset value practical expedient. These amounts are not required to be categorized in the fair value hierarchy. The investments can never be redeemed with the funds. Instead, distributions are received when liquidation of the underlying assets of the funds occur. It is estimated that the underlying assets will generally be liquidated between 5 and 10 years from the inception of the funds. The fair value of these investments is based on the net asset value (NAV) information provided by the general partner. Fair value is based on our proportionate share of the NAV based on the most recent partners' capital statements received from the general partners, which is generally one quarter prior to our balance sheet date. These values are then analyzed to determine if the NAV represents fair value at our balance sheet date, with adjustment being made where appropriate. We consider observable market data and perform a review validating the appropriateness of the NAV at each balance sheet date. It is likely that all of the investments will be redeemed at a future date for an amount different than the NAV of our ownership interest in partners' capital as of March 31, 2016 and December 31, 2015. During the three months ended March 31, 2016, no contributions were made and distributions totaling $0.3 million were received from these investments. During the year ended December 31, 2015, no contributions were made and distributions totaling $3.5 million were received from these investments. The amount of unfunded commitments related to the investments was $0.3 million as of March 31, 2016, and $0.6 million as of December 31, 2015.

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Level 3 Assets – Year-to-Date Change:




(in thousands)	Beginning balance at December 31, 2015		Included in earnings ⁽¹⁾		Included in other comprehensive income			Purchases		Sales			Transfers in and (out) of Level 3		Ending balance at March 31, 2016
Available-for-sale securities:
Corporate debt securities	$	69	$	15	$	27		$	3,539	$	(55	)	$	1,226	$	4,821
Collateralized debt obligations	8,577		4		(12		)	3,522		(54		)	0		12,037
Total fixed maturities	8,646		19		15			7,061		(109		)	1,226		16,858
Total available-for-sale securities	8,646		19		15			7,061		(109		)	1,226		16,858
Total Level 3 assets	$	8,646	$	19	$	15		$	7,061	$	(109	)	$	1,226	$	16,858


(1)	These amounts are reported in the Statement of Operations as net investment income and net realized investment losses for the three months ended March 31, 2016 on Level 3 securities.

We review the fair value hierarchy classifications each reporting period. Transfers between hierarchy levels may occur due to changes in the available market observable inputs. Transfers in and out of level classifications are reported as having occurred at the beginning of the quarter in which the transfers occurred.

There were no transfers between Level 1 and Level 2 for the three months ended March 31, 2016. Level 2 to Level 3 transfers totaled $1.3 million for nine fixed maturity holdings due to the use of unobservable market data to determine the fair value at March 31, 2016. Level 3 to Level 2 transfers totaled $0.1 million for one fixed maturity holding due to the use of observable market data to determine the fair value at March 31, 2016.

Level 3 Assets – Year-to-Date Change:




(in thousands)	Beginning balance at December 31, 2014		Included in earnings		Included in other comprehensive income		Purchases		Sales		Transfers in and (out) of Level 3		Ending balance at March 31, 2015
Available-for-sale securities:
Corporate debt securities	$	0	$	0	$	0	$	110	$	0	$	0	$	110
Total fixed maturities	0		0		0		110		0		0		110
Total available-for-sale securities	0		0		0		110		0		0		110
Total Level 3 assets	$	0	$	0	$	0	$	110	$	0	$	0	$	110

There were no transfers between Level 1 and Level 2 or between Level 2 and Level 3 for the three months ended March 31, 2015.

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Quantitative and Qualitative Disclosures about Unobservable Inputs

When a non-binding broker quote was the only input available, the security was classified within Level 3. Use of non-binding brokers quotes totaled $16.9 million at March 31, 2016. The unobservable inputs are not reasonably available to us.

The following table presents our fair value measurements on a recurring basis by pricing source:



(in thousands)	At March 31, 2016
	Total		Level 1		Level 2		Level 3
Fixed maturities:
Priced via pricing services	$	594,244	$	0	$	589,423	$	4,821
Priced via market comparables/broker quotes	12,037		0		0		12,037
Total fixed maturities	606,281		0		589,423		16,858
Common stock:
Priced via pricing services	11,887		11,887		0		0
Total common stock	11,887		11,887		0		0
Other investments:
Priced via unobservable inputs ⁽¹⁾	4,302		—		—		—
Total other investments	4,302		—		—		—
Total	$	622,470	$	11,887	$	589,423	$	16,858

(1)

Other investments measured at fair value represent real estate funds included on the balance sheet as limited partnership investments that are reported under the fair value option using the net asset value practical expedient. These amounts are not required to be categorized in the fair value hierarchy. The fair value of these investments is based on the net asset value (NAV) information provided by the general partner.

There were no assets measured at fair value on a nonrecurring basis during the three months ended March 31, 2016.

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Note 5. Investments

Available-for-sale securities

The following table summarizes the cost and fair value of our available-for-sale securities:



	At March 31, 2016
(in thousands)	Amortized cost		Gross unrealized gains		Gross unrealized losses		Estimated fair value
Available-for-sale securities:
States & political subdivisions	$	230,147	$	12,384	$	7	$	242,524
Corporate debt securities	257,320		1,302		2,124		256,498
Residential mortgage-backed securities	14,974		27		126		14,875
Commercial mortgage-backed securities	36,623		121		1,148		35,596
Collateralized debt obligations	55,123		61		414		54,770
Other debt securities	2,068		0		50		2,018
Total fixed maturities	596,255		13,895		3,869		606,281
Common stock	8,948		0		16		8,932
Total available-for-sale securities	$	605,203	$	13,895	$	3,885	$	615,213



	At December 31, 2015
(in thousands)	Amortized cost		Gross unrealized gains		Gross unrealized losses		Estimated fair value
Available-for-sale securities:
States & political subdivisions	$	221,093	$	10,761	$	7	$	231,847
Corporate debt securities	254,464		281		4,412		250,333
Residential mortgage-backed securities	13,639		4		130		13,513
Commercial mortgage-backed securities	38,630		30		1,089		37,571
Collateralized debt obligations	51,905		61		221		51,745
Other debt securities	2,241		0		41		2,200
Total fixed maturities	581,972		11,137		5,900		587,209
Common stock	12,865		0		133		12,732
Total available-for-sale securities	$	594,837	$	11,137	$	6,033	$	599,941

The amortized cost and estimated fair value of fixed maturities at March 31, 2016 are shown below by remaining contractual term to maturity. Mortgage-backed securities are allocated based upon their stated maturity dates. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.



	At March 31, 2016
(in thousands)	Amortized		Estimated
	cost		fair value
Due in one year or less	$	53,995	$	53,962
Due after one year through five years	275,900		277,046
Due after five years through ten years	174,612		181,441
Due after ten years	91,748		93,832
Total fixed maturities	$	596,255	$	606,281

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Available-for-sale securities in a gross unrealized loss position are as follows. Data is provided by length of time for securities in a gross unrealized loss position.



	At March 31, 2016
(dollars in thousands)	Less than 12 months				12 months or longer				Total
	Fair value		Unrealized losses		Fair value		Unrealized losses		Fair value		Unrealized losses		No. of holdings
Available-for-sale securities:
States & political subdivisions	$	6,938	$	7	$	0	$	0	$	6,938	$	7	3
Corporate debt securities	83,699		1,331		30,239		793		113,938		2,124		251
Residential mortgage-backed securities	5,333		12		2,886		114		8,219		126		7
Commercial mortgage-backed securities	9,321		77		17,371		1,071		26,692		1,148		22
Collateralized debt obligations	27,289		281		8,279		133		35,568		414		19
Other debt securities	1,950		50		68		0		2,018		50		2
Total fixed maturities	134,530		1,758		58,843		2,111		193,373		3,869		304
Common stock	0		0		8,932		16		8,932		16		1
Total available-for-sale securities	$	134,530	$	1,758	$	67,775	$	2,127	$	202,305	$	3,885	305
Quality breakdown of fixed maturities:
Investment grade	$	92,506	$	556	$	46,471	$	1,423	$	138,977	$	1,979	76
Non-investment grade	42,024		1,202		12,372		688		54,396		1,890		228
Total fixed maturities	$	134,530	$	1,758	$	58,843	$	2,111	$	193,373	$	3,869	304



	At December 31, 2015
(dollars in thousands)	Less than 12 months				12 months or longer				Total
	Fair value		Unrealized losses		Fair value		Unrealized losses		Fair value		Unrealized losses		No. of holdings
Available-for-sale securities:
States & political subdivisions	$	5,867	$	7	$	0	$	0	$	5,867	$	7	3
Corporate debt securities	172,831		2,447		19,086		1,965		191,917		4,412		349
Residential mortgage-backed securities	9,827		84		936		46		10,763		130		9
Commercial mortgage-backed securities	13,081		68		19,081		1,021		32,162		1,089		24
Collateralized debt obligations	27,981		103		9,174		118		37,155		221		19
Other debt securities	1,960		40		241		1		2,201		41		2
Total fixed maturities	231,547		2,749		48,518		3,151		280,065		5,900		406
Common stock	12,732		133		0		0		12,732		133		1
Total available-for-sale securities	$	244,279	$	2,882	$	48,518	$	3,151	$	292,797	$	6,033	407
Quality breakdown of fixed maturities:
Investment grade	$	174,723	$	1,296	$	38,369	$	1,256	$	213,092	$	2,552	105
Non-investment grade	56,824		1,453		10,149		1,895		66,973		3,348		301
Total fixed maturities	$	231,547	$	2,749	$	48,518	$	3,151	$	280,065	$	5,900	406

The above securities have been evaluated and determined to be temporary impairments for which we expect to recover our entire principal plus interest. The primary components of this analysis include a general review of market conditions and financial performance of the issuer along with the extent and duration at which fair value is less than cost. Any securities that we intend to sell or will more likely than not be required to sell before recovery are included in other-than-temporary impairments with the impairment charges recognized in earnings.

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Net investment income

Interest and dividend income are recognized as earned and recorded to net investment income. Investment income, net of expenses, was generated from the following portfolios:



(in thousands)	Three months ended March 31,
	2016		2015
Fixed maturities	$	4,526	$	4,079
Equity securities	35		260
Cash equivalents and other	324		294
Total investment income	4,885		4,633
Less: investment expenses	223		92
Net investment income	$	4,662	$	4,541

Realized investment gains (losses)

Realized gains and losses on sales of securities are recognized in income based upon the specific identification method. Realized gains (losses) on investments were as follows:



(in thousands)	Three months ended March 31,
	2016			2015
Available-for-sale securities:
Fixed maturities:
Gross realized gains	$	134		$	31
Gross realized losses	(1,583		)	(271		)
Net realized losses	(1,449		)	(240		)
Equity securities:
Gross realized gains	0			0
Gross realized losses	(34		)	0
Net realized losses	(34		)	0
Trading securities:
Common stock:
Gross realized gains	0			0
Gross realized losses	0			0
Increases in fair value⁽¹⁾	395			0
Net realized gains	395			0
Net realized investment losses	$	(1,088	)	$	(240	)


(1)	The fair value of our common stocks is determined based upon exchange traded prices provided by a nationally recognized pricing service.

Net impairment losses

The components of other-than-temporary impairments on investments were as follows:



(in thousands)	Three months ended March 31,
	2016			2015
Fixed maturities	$	(345	)	$	(120	)
Total other-than-temporary impairments	(345		)	(120		)
Portion recognized in other comprehensive income	0			0
Net impairment losses recognized in earnings	$	(345	)	$	(120	)

In considering if fixed maturity securities were credit-impaired, some of the factors considered include: potential for the default of interest and/or principal, level of subordination, collateral of the issue, compliance with financial covenants, credit ratings and industry conditions. We have the intent to sell all credit-impaired fixed maturity securities; therefore, the entire amount of the impairment charges were included in earnings and no non-credit impairments were recognized in other comprehensive income.

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Limited partnerships

Limited partnership investments, excluding certain real estate limited partnerships recorded at fair value, are generally reported on a one-quarter lag; therefore, our year-to-date limited partnership results through March 31, 2016 are comprised of partnership financial results for the fourth quarter of 2015. Given the lag in reporting, our limited partnership results do not reflect the market conditions of the first quarter of 2016. Cash contributions made to and distributions received from the partnerships are recorded in the period in which the transaction occurs.

Amounts included in equity in (losses) earnings of limited partnerships by method of accounting are included below:



(in thousands)	Three months ended March 31,
	2016			2015

Equity in (losses) earnings of limited partnerships accounted for under the equity method	$	(716	)	$	2,612
Change in fair value of limited partnerships accounted for under the fair value option	46			(254		)
Equity in (losses) earnings of limited partnerships	$	(670	)	$	2,358

The following table summarizes limited partnership investments by sector:



(in thousands)	At March 31, 2016		At December 31, 2015
Private equity	$	43,286	$	48,397
Mezzanine debt	12,611		12,701
Real estate	22,713		22,911
Real estate - fair value option	4,302		4,526
Total limited partnerships	$	82,912	$	88,535

See also Note 12, "Commitments and Contingencies" for investment commitments related to limited partnerships.

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Note 6. Bank Line of Credit

As of March 31, 2016, we have access to a $100 million bank revolving line of credit with a $25 million letter of credit sublimit that expires on November 3, 2020. As of March 31, 2016, a total of $99.0 million remains available under the facility due to $1.0 million outstanding letters of credit, which reduce the availability for letters of credit to $24.0 million. We had no borrowings outstanding on our line of credit as of March 31, 2016. Bonds with a fair value of $109.4 million were pledged as collateral on the line at March 31, 2016. The securities pledged as collateral have no trading restrictions and are reported as available-for-sale securities in the Statements of Financial Position as of March 31, 2016. The bank requires compliance with certain covenants, which include leverage ratios, for our line of credit. We are in compliance with all bank covenants at March 31, 2016.

Note 7. Postretirement Benefits

Pension plans

Our pension plans consist of a noncontributory defined benefit pension plan covering substantially all employees and an unfunded supplemental employee retirement plan for certain members of executive and senior management. Although we are the sponsor of these postretirement plans and record the funded status of these plans, the Exchange reimburses us for approximately 57% of the annual benefit expense of these plans, which represents pension benefits for our employees performing claims and life insurance functions.

A $17.4 million contribution was made to the defined benefit pension plan in the first quarter of 2016.

Prior to 2003, the employee pension plan purchased annuities from Erie Family Life Insurance Company ("EFL"), a wholly owned subsidiary of the Exchange, for certain plan participants that were receiving benefit payments under the pension plan. These are nonparticipating annuity contracts under which EFL has unconditionally contracted to provide specified benefits to beneficiaries; however, the pension plan remains the primary obligor to the beneficiaries. A contingent liability of $22.2 million at March 31, 2016 exists in the event EFL does not honor the annuity contracts.

The cost of our pension plans are as follows:



(in thousands)	Three months ended March 31,
	2016		2015
Service cost for benefits earned	7,050		7,608
Interest cost on benefits obligation	8,281		7,689
Expected return on plan assets	(9,880	)	(8,980	)
Prior service cost amortization	174		167
Net actuarial loss amortization	2,028		3,508
Pension plan cost ⁽¹⁾	7,653		9,992


(1)	Pension plan costs represent the total cost before reimbursements from the Exchange and EFL.

Note 8. Income Taxes

Our effective tax rate is calculated after consideration of permanent differences related to our investment revenues. Given that these amounts represent over 98% of the total permanent differences, the effective tax rate is approximately 35% when the investment related permanent differences are excluded.

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Note 9. Capital Stock

Class A and B common stock

Holders of Class B shares may, at their option, convert their shares into Class A shares at the rate of 2,400 Class A shares per Class B share. There were no shares of Class B common stock converted into Class A common stock during the three months ended March 31, 2016 and the year ended December 31, 2015. There is no provision for conversion of Class A shares to Class B shares, and, Class B shares surrendered for conversion cannot be reissued.

Stock repurchase program

In October 2011, our Board of Directors approved a continuation of the current stock repurchase program for a total of $150 million, with no time limitation. There were no shares repurchased under this program during the three months ended March 31, 2016 and the year ended December 31, 2015. We had approximately $17.8 million of repurchase authority remaining under this program at March 31, 2016.

Note 10. Accumulated Other Comprehensive Income (Loss)

Changes in accumulated other comprehensive income (loss) by component, including amounts reclassified out of accumulated other comprehensive income (loss) and the related line item in the Statements of Operations where net income is presented, are as follows:



(in thousands)	Three months ended March 31,
	2016			2015
Investment securities:
Accumulated other comprehensive income, beginning of the period	$	2,527		$	6,807
Other comprehensive income (loss) before reclassifications, net of tax (expense) benefit of $(1,226) and $72, respectively	2,277			(134		)
Reclassifications:
Realized investment losses, net of tax expense of $519 and $84, respectively	964			156
Impairment losses, net of tax expense of $121 and $42, respectively	224			78
Other comprehensive income, net of tax	3,465			100
Accumulated other comprehensive income, end of the period	$	5,992		$	6,907

Pension and other postretirement plans ⁽¹⁾:
Accumulated other comprehensive loss, beginning of the period	$	(99,391	)	$	(124,508	)
Other comprehensive income (loss) before reclassifications, net of tax	0			0
Reclassifications:
Amortization of prior service costs, net of tax	0			0
Amortization of net actuarial loss, net of tax	0			0
Other comprehensive income (loss), net of tax	0			0
Accumulated other comprehensive loss, end of the period	$	(99,391	)	$	(124,508	)

Total
Accumulated other comprehensive loss, beginning of the period	$	(96,864	)	$	(117,701	)
Investment securities	3,465			100
Pension and other postretirement plans	0			0
Other comprehensive income, net of tax	3,465			100
Accumulated other comprehensive loss, end of the period	$	(93,399	)	$	(117,601	)


(1)	There are no comprehensive income items or amounts reclassified out of accumulated other comprehensive loss related to postretirement plan items during interim periods.

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Note 11. Concentrations of Credit Risk

Financial instruments could potentially expose us to concentrations of credit risk, including unsecured receivables from the Exchange. A large majority of our revenue and receivables are from the Exchange and affiliates. See also Note 1, "Nature of Operations". Management fee amounts and other reimbursements due from the Exchange and affiliates were $352.5 million and $348.1 million at March 31, 2016 and December 31, 2015, respectively.

Note 12. Commitments and Contingencies

We have contractual commitments to invest up to $19.1 million related to our limited partnership investments at March 31, 2016. These commitments are split among private equity securities of $7.3 million, mezzanine debt securities of $8.5 million, and real estate activities of $3.3 million. These commitments will be funded as required by the limited partnership agreements.

We are involved in litigation arising in the ordinary course of conducting business. In accordance with current accounting standards for loss contingencies and based upon information currently known to us, we establish reserves for litigation when it is probable that a loss associated with a claim or proceeding has been incurred and the amount of the loss or range of loss can be reasonably estimated. When no amount within the range of loss is a better estimate than any other amount, we accrue the minimum amount of the estimable loss. To the extent that such litigation against us may have an exposure to a loss in excess of the amount we have accrued, we believe that such excess would not be material to our financial condition, results of operations, or cash flows. Legal fees are expensed as incurred. We believe that our accruals for legal proceedings are appropriate and, individually and in the aggregate, are not expected to be material to our financial condition, operations, or cash flows.

We review all litigation on an ongoing basis when making accrual and disclosure decisions. For certain legal proceedings, we cannot reasonably estimate losses or a range of loss, if any, particularly for proceedings that are in their early stages of development or where the plaintiffs seek indeterminate damages. Various factors, including, but not limited to, the outcome of potentially lengthy discovery and the resolution of important factual questions, may need to be determined before probability can be established or before a loss or range of loss can be reasonably estimated. If the loss contingency in question is not both probable and reasonably estimable, we do not establish an accrual and the matter will continue to be monitored for any developments that would make the loss contingency both probable and reasonably estimable. In the event that a legal proceeding results in a substantial judgment against, or settlement by, us, there can be no assurance that any resulting liability or financial commitment would not have a material adverse effect on the financial condition, results of operations, or cash flows.

Note 13. Subsequent Events

No items were identified in this period subsequent to the financial statement date that required adjustment or additional disclosure.

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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, 2015, as contained in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on February 25, 2016.

INDEX



	Page Number
Cautionary Statement Regarding Forward-Looking Information	20
Recent Accounting Standards	21
Operating Overview	21
Results of Operations	24
Financial Condition	28
Liquidity and Capital Resources	30
Critical Accounting Estimates	31

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;


•	costs of providing services to the Exchange under the subscriber’s agreement;


•	credit risk from 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;


◦	emerging claims and coverage issues in the industry; and


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


•	ability to attract and retain talented management and employees;


•	ability to maintain uninterrupted business operations;


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


•	our ability to meet liquidity needs and access capital; and


•	outcome of pending and potential litigation.

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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.

RECENT ACCOUNTING STANDARDS

We adopted amended guidance related to the consolidation of legal entities effective December 31, 2015, as required under generally accepted accounting principles. As a result of this new guidance, we are not deemed to have a variable interest in the Erie Insurance Exchange ("Exchange") as the fees paid for services provided to the Exchange no longer represent a variable interest. The compensation received from the attorney-in-fact fee arrangement with the subscribers is for services provided by us acting in our role as attorney-in-fact and is commensurate with the level of effort required to perform those services. Following adoption of the new accounting guidance, the Exchange’s results are no longer required to be consolidated with ours. No longer consolidating the Exchange resulted in no change to our net income or equity.

See Part I, Item 1. "Financial Statements - Note 2, Significant Accounting Policies, of Notes to Financial Statements" contained within this report for a discussion of this adopted standard as well as other recently issued accounting standards and the impact on our financial statements if known.

OPERATING OVERVIEW

Overview

We serve as the attorney-in-fact for the subscribers (policyholders) at the Exchange, a reciprocal insurer that writes personal and commercial property and casualty insurance. Our primary function is to perform certain services relating to the sales, underwriting and issuance of policies on behalf of the Exchange.

The Exchange is a reciprocal insurance exchange, which is an unincorporated association of individuals, partnerships and corporations that agree to insure one another. Each applicant for insurance to the Exchange signs a subscriber's agreement, which contains an appointment of Indemnity as their attorney-in-fact to transact business on their behalf.

Pursuant to the subscriber’s agreement and for its services as attorney-in-fact, we earn a management fee calculated as a percentage of the direct and assumed premiums written by the Exchange. Our earnings are primarily driven by the management fee revenue generated for the services we provide relating to certain sales, underwriting, and issuance of policies for the Exchange.

The sales related services we provide to the Exchange 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 expenses. The underwriting services we provide include underwriting and policy processing expenses. We provide information technology services that support all functions as well as customer service and administrative services.

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 assumed premiums written by the Exchange. The Exchange generates revenue by insuring preferred and standard risks, with personal lines comprising 70% of the 2015 direct and assumed written premiums and commercial lines comprising the remaining 30%. The principal personal lines products are private passenger automobile and homeowners. The principal commercial lines products are commercial multi-peril, workers compensation and commercial automobile.

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Financial Overview



	Three months ended March 31,
(dollars in thousands, except per share data)	2016		2015		% Change
	(Unaudited)
Total operating revenue	$	374,728	$	350,831	6.8		%
Total operating expenses	307,063		298,401		2.9
Net revenue from operations	67,665		52,430		29.1
Total investment income	2,559		6,539		(60.9	)
Income before income taxes	70,224		58,969		19.1
Income tax expense	24,329		20,136		20.8
Net income	$	45,895	$	38,833	18.2		%
Net income per share - diluted	$	0.87	$	0.74	18.4		%

Total operating revenue increased 6.8% in the first quarter of 2016 compared to the first quarter of 2015 driven by the increase in management fee revenue. The two components of management fee revenue are the management fee rate we charge, and the direct and assumed premiums written by the Exchange. The management fee rate was 25% for both 2016 and 2015. The direct and assumed premiums written by the Exchange were $1.5 billion in the first quarter of 2016 and $1.4 billion in the first quarter of 2015.

Total operating expenses increased 2.9% in the first quarter of 2016 compared to the first quarter of 2015. The increase in operating expenses was driven by an increase in commissions, partially offset by lower non-commission expenses from information technology and administrative and other costs.

Gross margin from operations increased to 18.1% in the first quarter of 2016 from 14.9% in the first quarter of 2015.

Total investment income decreased 60.9% in the first quarter of 2016 compared to the first quarter of 2015 due to higher realized losses on investments and losses from limited partnership investments.

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Reconciliation of Operating Income to Net Income

We disclose operating income, a non-GAAP financial measure, to enhance our investors’ understanding of our performance. Our method of calculating this measure may differ from those used by other companies, and therefore comparability may be limited.

We define operating income as net income excluding realized capital gains and losses, impairment losses, and related federal income taxes.

We use operating income to evaluate the results of our operations. It reveals trends that may be obscured by the net effects of realized capital gains and losses including impairment losses. Realized capital gains and losses, including impairment losses, may vary significantly between periods and are generally driven by business decisions and economic developments such as capital market conditions which are not related to our ongoing operations. We are aware that the price to earnings multiple commonly used by investors as a forward-looking valuation technique uses operating income as the denominator. Operating income should not be considered as a substitute for net income prepared in accordance with U.S. generally accepted accounting principles ("GAAP") and does not reflect our overall profitability.

The following table reconciles operating income and net income:



(in thousands, except per share data)	Three months ended March 31,
	2016			2015
	(Unaudited)
Operating income	$	46,827		$	39,067
Net realized losses and impairments on investments	(1,433		)	(360		)
Income tax benefit	501			126
Realized losses and impairments, net of income taxes	(932		)	(234		)
Net income	$	45,895		$	38,833

Per Class A common share-diluted:
Operating income	$	0.89		$	0.74
Net realized losses and impairments on investments	(0.03		)	0.00
Income tax benefit	0.01			0.00
Realized losses and impairments, net of income taxes	(0.02		)	0.00
Net income	$	0.87		$	0.74

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. Further, unanticipated increased inflation costs including medical cost inflation, construction and auto repair cost inflation, and tort issues may impact the estimated loss reserves and future premium rates. If any of these items impacted the financial condition or continuing operations of the Exchange, it could have an impact on our financial results.

Financial market volatility

Our portfolio of fixed maturity, equity security, and limited partnership 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.

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RESULTS OF OPERATIONS

We earn management fee revenue from providing services relating to the sales, underwriting, and issuance of policies on behalf of the Exchange as a result of its attorney-in-fact relationship. A summary of the financial results of these operations is as follows:



	Three months ended March 31,
(dollars in thousands)	2016			2015			% Change
	(Unaudited)
Management fee revenue, net	$	367,458		$	343,234		7.1		%
Service agreement revenue	7,270			7,597			(4.3	)
Total operating revenue	374,728			350,831			6.8
Total operating expenses	307,063			298,401			2.9
Net revenue from operations	$	67,665		$	52,430		29.1		%
Gross margin	18.1		%	14.9		%	3.2		pts.

Management fee revenue

Management fee revenue is based upon all direct and assumed premiums written by the Exchange and 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 2016 and 2015. Changes in the management fee rate can affect our revenue and net income significantly. Management fee revenue is calculated by multiplying the management fee rate by the direct and assumed premiums written by the Exchange. The following table presents the calculation of management fee revenue:



	Three months ended March 31,
(dollars in thousands)	2016			2015			% Change
	(Unaudited)
Direct and assumed premiums written by the Exchange	$	1,474,632		$	1,377,338		7.1	%
Management fee rate	25		%	25		%
Management fee revenue, gross	368,658			344,334			7.1
Change in allowance for management fee returned on cancelled policies⁽¹⁾	(1,200		)	(1,100		)	NM
Management fee revenue, net of allowance	$	367,458		$	343,234		7.1	%

NM = not meaningful


(1)	Management fees are returned to the Exchange when policies are cancelled mid-term and unearned premiums are refunded. We record an estimated allowance for management fees returned on mid-term policy cancellations.

Direct and assumed premiums written by the Exchange

Direct and assumed premiums include premiums written directly by the Exchange and premiums assumed from its wholly owned property and casualty subsidiaries. Direct and assumed premiums written by the Exchange increased 7.1% to $1.5 billion in the first quarter of 2016 compared to the first quarter of 2015, driven by increases in both policies in force and average premium per policy. Year-over-year policies in force for all lines of business increased 3.6% in the first quarter of 2016 as the result of continuing strong policyholder retention and an increase in new policies written, compared to 4.2% in the first quarter of 2015. The year-over-year average premium per policy for all lines of business increased 3.4% at March 31, 2016, compared to 4.2% at March 31, 2015.

Premiums generated from new business increased 6.8% to $180 million in the first quarter of 2016, compared to an increase of 11.1% to $168 million in the first quarter of 2015. Underlying the trend in new business premiums was a 4.8% increase in new business policies written in the first quarter of 2016, compared to 7.1% in the first quarter of 2015, while the year-over-year average premium per policy on new business increased 1.2% at March 31, 2016, compared to 3.9% at March 31, 2015.

Premiums generated from renewal business increased 7.1%