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Information, analysis and actionable ideas to help you see the other side of the Wall Street hype machine.
Information, analysis and actionable ideas to help you see the other side of the Wall Street hype machine.
After conducting a forensic financial review of Erie Indemnity Company (NASDAQ: ERIE or “the Company”), a $25 billion dollar valued public company in the property and casualty insurance industry that serves as the attorney-in-fact for its sole client, the policyholders of Erie Insurance Exchange (“Exchange”), we have grave concerns about the sustainability of ERIE’s 25% management fee collected on premiums written by the Exchange. ERIE’s structure creates a dual fiduciary mandate for it to balance responsibilities to both ERIE public shareholders and Exchange policyholders. Notably, ERIE is the only public company that is structured in this way, with a publicly traded management company overseeing a policyholder-owned insurance exchange.
We believe that ERIE's recent addition to both the S&P 400 MidCap in August2023 and S&P 500 in late September 2024 likely attracted bullish index-mimicking investors, making it one of the best-performing stocks among large-cap insurance peers in 2024. On the surface, ERIE’s financial performance has also improved with revenue accelerating to a mid-teens growth rate. Bulls often highlight ERIE's structure as a shield against short-term EPS volatility typical of traditional P&C insurers, as it seemingly removes underwriting and balance sheet risks in the short term, as those risk are isolated to the Exchange.
However, buying ERIE on the face value of its reported SEC-filed financial results does not tell the whole story because the Exchange’s financials are filed separately. Since the end of 2021, ERIE has profited substantially from the Exchange while bearing no insurance risk. Conversely, the Exchange, carrying all insurance risk, has incurred significant losses and a rapidly diminishing surplus. Over the past two and a half years, the Exchange has suffered $4.2 billion in operating losses and a $2.5 billion decrease in surplus, while in complete contrast, ERIE's operating profits have blossomed reaching $1.2 billion during the same period. This combination of sustained underwriting losses, significant surplus reduction, and an elevated premium-to-surplus ratio at the Exchange mirrors the 2000-2002 period. During that time, similar financial indicators shifted the fiduciary focus back to policy holders, resulting in a management fee reduction below the 25% maximum which directly impacts ERIE’s earnings.
Given the recent deterioration of the Exchange’s financial performance and historical precedent, we believe it is increasingly likely that ERIE’s management fee will decline for the first time in decades which could reset earnings expectations by approximately 20% and slow premium growth at the Exchange over the coming years. Many shareholders who have entered the stock in the last 15 years may be unaware that the fee was once below 25% or may not closely examine statutory insurance filings to understand the Exchange's standalone performance and competitive position.
In Q4 2002, ERIE's former president commented on the fee reduction: “I would like to touch on the management fee reduction we announced in December. First of all, the Erie Indemnity Company Board of Directors sees the management fee as a tool to balance the interest of the shareholders, of the Erie Indemnity Company with the policyholders of the exchange. Keep in mind the exchange assumes 94.5% of the total underwriting risk and is the only corporate customer of the Erie Indemnity Company. Given the strong revenues and earnings growth of the Erie Indemnity Company and the underwriting loses we are experiencing at the Exchange, the Board opted this past December to reduce the management fee from 25 to 24%.”
Recent actions by AM Best, a credit rating specialist in the insurance industry, also support our opinion about lurking financial issues. In August 2024, AM Best revised its outlook for Erie Insurance Group’s Members to negative from stable. The last ratings down grade occurred in 2003 after the management fee was cut. These are the only two AM Best credit revisions this century.
Several policyholder lawsuits have alleged ERIE's breach of fiduciary duty, with one case ongoing.(1) Compared with other reciprocal insurers like Farmers Insurance, ERIE charges a higher management fee. Farmers, despite being allowed a 20% maximum fee, charged 13% on over $6billion of written premiums in 2023. ERIE, has consistently charged 25% since2007.
The disappearance of ERIE’s “Exchange Relationship Committee" from its Board committees after the 2020 proxy raises concerns about its commitment to policy holder obligations. The committee, which existed since 2008 but reportedly hadn't met for several years, was presumably responsible for overseeing the relationship between Erie Indemnity Co. and Erie Insurance Exchange. ERIE’s MSCI ESG rating dropped to B from BB during the period the committee was removed. ERIE is in the bottom 9% of all P&C insurers rated and was cited as a laggard in “corporate behavior”, “corporate governance” and “responsible investment”.
Our market share analysis reveals that the Exchange has the most aggressive underwriting profile among its peers, with the largest loss and combined ratios, and the most severe degradation in its combined ratio since 2021. Per Bloomberg, ERIE is covered by only one sell-side analyst who has no price target and who assumes a 25% management fee on approximately $13.6billion in written premiums at the Exchange for 2025. We estimate a fee reduction to 24% would decrease EPS by over $2.00. ERIE also trades at a record high 46x P/E multiple despite growing risk of a fee reduction and slower premium growth at the Exchange. Previously, when ERIE reduced its management fee, the P/E multiple contracted by approximately 10x. If history repeated, this would yield a fair value estimate of $217 - $314 per share which suggests35% - 55% potential downside risk. Furthermore, we expect ERIE’s share price to under perform the P&C insurance and broader equity market indices.
We believe ERIE’s share price has benefited from multiple index inclusion catalysts and the belief that its increasing financial performance is sustainable. ERIE only has one sell-side analyst offering estimates which makes its earnings “surprises” somewhat artificial. ERIE’s SEC-filed financial results do not show that its sole client – ERIE Insurance Exchange – is struggling and could result in a management fee reduction which would impact ERIE’s financial results.
The research note can be found at www.sprucepointcap.com and updates will be posted on twitter @sprucepointcap
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