ISABELLA BANK CORP 10-K

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. ISABELLA BANK CORPORATION FINANCIAL REVIEW (Dollars in thousands except per share amounts) The following is management’s discussion and analysis of our financial condition and results of operations. This discussion and analysis is intended to provide a better understanding of the consolidated financial statements and statistical data included elsewhere in this Annual Report on Form 10-K. Executive Summary We reported net income of $10,885 and earnings per common share of $1.37 for the year ended December 31, 2020. Net income and earnings per common share for the year ended December 31, 2019 were $13,024 and $1.65, respectively. A decline in the interest rate environment was a large driver of a $3,134 decrease in interest income for 2020 when compared to 2019. Interest expense on deposits and borrowings decreased $4,036 for the year ended December 31, 2020 when compared to the same period in 2019 primarily due to reduced interest rates and reduced reliance on higher-cost borrowings. Net interest income increased by $902 for the year ended December 31, 2020 in comparison to the prior year. The provision for loan losses increased by $1,635 in 2020 when compared to 2019 as the result of increased economic and environmental risk factors, predominantly driven by COVID-19. Noninterest income for the year ended December 31, 2020 increased $6,384 when compared to 2019 mainly as a result of net gain on sold mortgage loans and the redemption of corporate owned life insurance policies. Our joint venture investment in Corporate Settlement Solutions, LLC (“CSS”) also contributed to the variance in noninterest income. We sold our membership interest in CSS during the fourth quarter of 2020, which resulted in a $394 reduction in income. During the fourth quarter of 2019, we recorded a reduction of $3,566 in our joint venture investment in CSS due to CSS' recorded impairment of intangible assets. Noninterest expenses for the year ended December 31, 2020 increased $8,183 when compared to 2019, which can be attributed to a $7,643 cost to extinguish $100,000 of FHLB advances. As a result of this debt extinguishment, future interest expense and net yields are expected to be impacted favorably. As of December 31, 2020, total assets and assets under management were $1,957,378 and $2,702,722, respectively. Assets under management include loans sold and serviced of $301,377 and investment and trust assets managed by Isabella Wealth of $443,967, in addition to assets on our consolidated balance sheet. In the first half of 2020, the Bank’s investment and trust services business was re-engineered and rebranded as Isabella Wealth to enhance the client experience, build scalability, and expand market awareness. Loans outstanding as of December 31, 2020 totaled $1,238,311. During 2020, gross loans increased $51,741 which was largely the result of SBA PPP loans in the commercial loan portfolio. Our securities portfolio declined $90,611 since December 31, 2019, predominantly as a result of increased monthly prepayments and payoffs of AFS securities. Due to the flat yield curve that has existed for the last few years, the opportunity to identify new investment securities for purchase at an acceptable yield has been minimal. Based on strategic objectives, we utilized this available cash flow to reduce higher-cost funding sources and other borrowings as they matured. Total deposits increased $252,466 during the year, driven by growth in demand and savings deposits, and totaled $1,566,317 as of December 31, 2020. All regulatory capital ratios for the Bank exceeded the minimum thresholds to be considered a “well capitalized” institution. Our net yield on interest earning assets (FTE) was 2.96% for 2020 which declined from 3.07% in 2019. Management implemented strategic programs focused on improving our net yield on interest earning assets, which includes enhanced pricing related to loans and a reduced reliance on higher-cost borrowed funds and brokered deposits as funding sources. While these efforts have helped, the current interest rate environment has had a negative impact on the yield of interest earning assets and future improvements may be gradual. We are committed to increasing earnings and shareholder value through growth in our loan portfolio while maintaining strong underwriting standards, growth in our wealth management services, managing operating costs and increasing our presence within our geographical footprint. Recent Events and Legislation Restricted Stock Plan: On June 24, 2020, the Board of Directors adopted the RSP, an equity-based bonus plan. The RSP authorizes the issuance of unvested restricted stock to an eligible employee with a maximum award ranging from 25% to 40% of the employee’s annual salary, on a calendar year basis. Under the RSP, the Board of Directors may grant restricted stock awards to eligible employees on an annual basis based on the satisfactory achievement of performance targets and measures established by the Board of Directors. If these grant conditions are not satisfied, then the award of restricted shares will lapse or be adjusted appropriately, at the discretion of the Board of Directors. Restricted stock awards granted are not fully transferable or vested until certain conditions are met, as stated in the plan. In connection with the adoption of the RSP, the Isabella Bank Corporation Stock Award Incentive Plan was terminated. 14 Table of Contents Also on June 24, 2020, we made initial awards under the RSP to Isabella Bank's CEO, President, and CFO. As of December 31, 2020, certain targets specified in the award agreements pursuant to the RSP were achieved and therefore, we recognized compensation expense of $14 pursuant to the RSP. Additional disclosures about the RSP are included in “Note 13 – Benefit Plans” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data. Executive Cash Incentive Plan: Also on June 24, 2020, we amended and restated the Isabella Bank Corporation Employee Cash Incentive Plans to create two separate plans: one for non-executive employees and the other, the Isabella Bank Corporation Executive Cash Incentive Plan for executive employees. The executive plan provides separate potential payouts for Isabella Bank's CEO, President and CFO based on achievement of personal and corporate goals. The potential payouts under the plan range from 20% to 30% of the employee's annual salary. Impact of COVID-19: Unexpected and unprecedented changes have occurred during 2020 and into 2021 as the result of COVID-19. This aggressive and persistent virus causes a respiratory disease and can result in serious illness or death. The World Health Organization has declared the situation a global pandemic. The pandemic has created significant market volatility, economic uncertainty, and disruption to normal business operations around the world, with slowdowns and shutdowns affecting entire industries. The Michigan governor issued on March 23, 2020 a stay-at-home order, which limited gatherings and travel, and required those in select businesses who were not deemed essential to sustain or protect life to stay home. The Michigan stay-at-home order was in effect until early June. Additional executive and Michigan State Health Department orders have been put in place since June 2020. During the fourth quarter of 2020, certain restrictions were put in place on industries within our communities and continued through December 31, 2020. The orders, as the result of COVID-19, led to financial stress for many businesses and their employees throughout the communities we serve. The CARES Act, an unprecedented federal government support program, was enacted on March 27, 2020 in response to the COVID-19 pandemic. It is a $2 trillion stimulus package intended to provide financial relief across the country. The CARES Act included the PPP, which enabled businesses to obtain a forgivable SBA loan to meet payroll, rent, utility, and mortgage interest obligations for the 24-week period following the loan origination, and re-open quickly once the public health crisis ends. The first applications for PPP funds, with a term of two years, were accepted April 3, 2020. During 2020, we were privileged to have facilitated more than 950 SBA PPP loans for a total of $99,459 and we are pleased to have the opportunity to provide additional funding in 2021 under an additional government stimulus program. Bank regulators issued an interim rule that neutralizes the regulatory capital effects by allowing a zero percent risk weight, for capital purposes, to loans originated under the PPP. The capital rule was issued April 9, 2020, with an immediate effective date. During 2020, many of our customers expressed their general concern about the uncertain economic conditions, but it is still premature to reasonably predict the magnitude of the impact. One measure we took to assist our customers included reduced service charges and fees on deposit accounts. Since the COVID-19 pandemic led to an increase in the need for electronic services and products, we elected to temporarily waive certain charges and fees, and permanently remove some charges and fees, to ease the financial stress on our customers. Other measures we have taken to assist our customers include loan programs that provide short-term payment relief. Under these programs, borrowers whose loans were in good standing as of March 1, 2020 could elect to defer full or partial payments for a period not to exceed 180 days. Loan payment deferrals totaled $306,103, or 23.8% of gross loans, as of June 30, 2020. As of September 30, 2020, active loan payment deferrals declined to $103,858, or 8.0% of gross loans, as the majority of borrowers granted loan payment deferrals had reverted back to contractual payments. As of December 31, 2020, active loan payment deferrals declined even further and totaled $6,048, or 0.5% of gross loans. Bank regulators issued a statement on March 22, 2020, and a revised statement on April 7, 2020, which provided confirmation that short-term loan modifications made on a good faith basis in response to COVID-19 to borrowers with a current payment status are not categorized as TDRs. Pursuant to this guidance, borrowers granted a short-term loan modification meeting this criteria were not categorized as TDR as of December 31, 2020. These programs, along with the SBA PPP, could mask or delay the detection or reporting of deterioration in credit quality indicators. The extent to which COVID-19 impacts our business will depend on future developments, which are highly uncertain and cannot be predicted with any accuracy. Future developments include new information which may emerge concerning the severity of COVID-19 and the actions to contain the coronavirus or treat its impact, among others. We expect the significance of the pandemic, including the extent of its effect on our financial and operational results, to be dictated by, among other factors, its duration, the success of efforts to contain it and the impact of actions taken in response, including the development and distribution of effective vaccines. Uncertainty created by the pandemic is pervasive, and has impacted our operations, customers, and various areas of risk. With the uncertainty created by COVID-19, it's challenging to determine the full impact 15 Table of Contents on our ongoing financial and operational results. We continue to closely monitor external events and are in continual discussion with our customers to assess, prepare and respond to conditions as they evolve. Reclassifications Certain amounts reported in management's discussion and analysis of financial condition and results of operations for 2019 and 2018 have been reclassified to conform with the 2020 presentation. Other assets and other liabilities on the consolidated balance sheets were decreased by $1,555 as of December 31, 2019 to reclassify pension liabilities. This resulted in a $1,555 decrease in total assets and total liabilities as of December 31, 2019. All other balances and ratios were not materially impacted. Subsequent Events We evaluated subsequent events after December 31, 2020 through the date our consolidated financial statements were issued for potential recognition and disclosure. No subsequent events require financial statement recognition or disclosure between December 31, 2020 and the date our consolidated financial statements were issued. Other We have not received, nor are aware of, any notices of regulatory actions as of March 9, 2021. CRITICAL ACCOUNTING POLICIES Our significant accounting policies are set forth in “Note 1 – Nature of Operations and Summary of Significant Accounting Policies” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data. Of these significant accounting policies, we consider our policies regarding the ALLL, acquisition intangibles and goodwill, and the determination of the fair value and assessment of OTTI of investment securities to be our most critical accounting policies. The ALLL requires our most subjective and complex judgment. Changes in economic conditions and other external factors can have a significant impact on the ALLL and, therefore, the provision for loan losses and results of operations. We have developed policies and procedures for assessing the appropriateness of the ALLL, recognizing that this process requires a number of assumptions and estimates with respect to our loan portfolio. Our assessments may be impacted in future periods by changes in economic conditions, and the discovery of information with respect to borrowers which is not known to us at the time of the issuance of the consolidated financial statements. For additional discussion concerning our ALLL and related matters, see “Allowance for Loan and Lease Losses” and “Note 4 – Loans and ALLL” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data. U.S. generally accepted accounting principles require that we determine the fair value of the assets and liabilities of an acquired entity, and record the fair value on the date of acquisition. We employ a variety of measures in the determination of the fair value, including the use of discounted cash flow analysis, market appraisals, and projected future revenue streams. For certain items that we believe we have the appropriate expertise to determine the fair value, we may choose to use our own calculations of the value. In other cases, where the value is not easily determined, we consult with independent experts to determine the fair value of the identified asset or liability. Once valuations have been determined, the net difference between the price paid for the acquired entity and the net value of assets acquired on our balance sheet, including identifiable intangibles, is recorded as goodwill. Acquisition intangibles and goodwill are qualitatively evaluated to determine if it is more likely than not that the carrying balance is impaired on at least an annual basis. During the fourth quarter of 2020, we engaged a third-party valuation firm to perform a quantitative analysis of goodwill as of December 31, 2020. In determining the fair value of the Bank and Isabella Bank Corporation, the third-party firm assessed general economic conditions, industry and market considerations, the impact of recent events to financial performance, the market price of our common stock, and other relevant events. Based on the valuation prepared, it was determined that our estimated fair values of the Bank and Isabella Bank Corporation at December 31, 2020 were greater than our recorded book value and no impairment of goodwill was identified. The carrying amount of goodwill as of December 31, 2020 relied on assumptions and use of estimates pursuant to the valuations obtained. AFS securities are carried at fair value with changes in the fair value included as a component of other comprehensive income. Declines in the fair value of AFS securities below their cost that are other-than-temporary are reflected as realized losses in the consolidated statements of income. We evaluate AFS securities for indications of losses that are considered other-than-temporary, if any, on a regular basis. The market values for most AFS investment securities are typically obtained from outside sources and applied to individual securities within the portfolio. Municipal securities for which no readily determinable market values are available are priced using fair value curves which most closely match the securities' characteristics. 16 Table of Contents Average Balances, Interest Rates, and Net Interest Income The following schedules present the daily average amount outstanding for each major category of interest earning assets, non-earning assets, interest bearing liabilities, and noninterest bearing liabilities for the last three years. These schedules also present an analysis of interest income and interest expense for the periods indicated. All interest income is reported on a FTE basis using a federal income tax rate of 21%. Loans in nonaccrual status, for the purpose of the following computations, are included in the average loan balances. FRB and FHLB restricted equity holdings are included in other interest earning assets. Year Ended December 31 2020 2019 2018 Average Balance Tax Equivalent Interest Average Yield / Rate Average Balance Tax Equivalent Interest Average Yield / Rate Average Balance Tax Equivalent Interest Average Yield / Rate INTEREST EARNING ASSETS Loans $ 1,236,169 $ 54,102 4.38 % $ 1,162,210 $ 54,192 4.66 % $ 1,120,021 $ 49,229 4.40 % Taxable investment securities (1) 229,468 5,214 2.27 % 296,758 7,185 2.42 % 341,095 8,294 2.43 % Nontaxable investment securities 140,665 5,189 3.69 % 169,049 6,380 3.77 % 191,281 7,115 3.72 % Fed funds sold 4 — 0.06 % 64 2 2.48 % 4 — — % Other 142,717 1,026 0.72 % 38,549 1,199 3.11 % 28,255 1,062 3.76 % Total earning assets 1,749,023 65,531 3.75 % 1,666,630 68,958 4.14 % 1,680,656 65,700 3.91 % NONEARNING ASSETS Allowance for loan losses (8,837) (8,256) (8,094) Cash and demand deposits due from banks 24,987 20,057 19,770 Premises and equipment 25,846 27,035 28,349 Accrued income and other assets 118,195 108,073 95,359 Total assets $ 1,909,214 $ 1,813,539 $ 1,816,040 INTEREST BEARING LIABILITIES Interest bearing demand deposits $ 262,188 $ 357 0.14 % $ 230,570 $ 305 0.13 % $ 229,411 $ 267 0.12 % Savings deposits 456,088 1,212 0.27 % 388,821 2,572 0.66 % 361,743 1,698 0.47 % Time deposits 387,881 7,315 1.89 % 429,745 8,731 2.03 % 454,916 7,296 1.60 % Borrowed funds 245,969 4,941 2.01 % 304,888 6,253 2.05 % 344,352 6,370 1.85 % Total interest bearing liabilities 1,352,126 13,825 1.02 % 1,354,024 17,861 1.32 % 1,390,422 15,631 1.12 % NONINTEREST BEARING LIABILITIES Demand deposits 320,820 237,675 224,777 Other 15,613 13,337 7,597 Shareholders’ equity 220,655 208,503 193,244 Total liabilities and shareholders’ equity $ 1,909,214 $ 1,813,539 $ 1,816,040 Net interest income (FTE) $ 51,706 $ 51,097 $ 50,069 Net yield on interest earning assets (FTE) 2.96 % 3.07 % 2.98 % (1) Includes taxable AFS securities and equity securities Net interest income is the amount by which interest income on earning assets exceeds the interest expense on interest bearing liabilities. Net interest income is influenced by changes in the balance and mix of assets and liabilities, as well as market interest rates. We exert some control over these factors; however, FRB monetary policy and competition have a significant impact. For analytical purposes, net interest income is adjusted to an FTE basis by including the income tax savings from interest on tax exempt loans and nontaxable investment securities, thus making year to year comparisons more meaningful. The FTE adjustment is based on a federal income tax rate of 21%. 17 Table of Contents Volume and Rate Variance Analysis The following table sets forth the effect of volume and rate changes on interest income and expense for the periods indicated. For the purpose of this table, changes in interest due to volume and rate were determined as follows: Volume—change in volume multiplied by the previous period's FTE rate. Rate—change in the FTE rate multiplied by the previous period's volume. All interest income presented in the table below is reported on a FTE basis using a federal income tax rate of 21%. The change in interest due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each. 2020 Compared to 2019 Increase (Decrease) Due to 2019 Compared to 2018 Increase (Decrease) Due to Volume Rate Net Volume Rate Net Changes in interest income Loans $ 3,341 $ (3,431) $ (90) $ 1,898 $ 3,065 $ 4,963 Taxable investment securities (1,550) (421) (1,971) (1,074) (35) (1,109) Nontaxable investment securities (1,050) (141) (1,191) (838) 103 (735) Fed Funds Sold (1) (1) (2) — 2 2 Other 1,301 (1,474) (173) 342 (205) 137 Total changes in interest income 2,041 (5,468) (3,427) 328 2,930 3,258 Changes in interest expense Interest bearing demand deposits 43 9 52 1 37 38 Savings deposits 385 (1,745) (1,360) 135 739 874 Time deposits (815) (601) (1,416) (422) 1,857 1,435 Borrowed funds (1,186) (126) (1,312) (771) 654 (117) Total changes in interest expense (1,573) (2,463) (4,036) (1,057) 3,287 2,230 Net change in interest margin (FTE) $ 3,614 $ (3,005) $ 609 $ 1,385 $ (357) $ 1,028 The flattening of the yield curve continues to place pressure on our net interest margin. Despite this pressure, we experienced improvement as a result of a decline in higher-cost deposits and borrowings. Average Yield / Rate for the Three-Month Periods Ended: December 31 2020 September 30 2020 June 30 2020 March 31 2020 December 31 2019 Total earning assets 3.66 % 3.61 % 3.74 % 3.99 % 4.13 % Total interest bearing liabilities 0.83 % 0.95 % 1.07 % 1.26 % 1.34 % Net yield on interest earning assets (FTE) 3.04 % 2.89 % 2.92 % 2.98 % 3.06 % Quarter to Date Net Interest Income (FTE) December 31 2020 September 30 2020 June 30 2020 March 31 2020 December 31 2019 Total interest income (FTE) $ 16,722 $ 16,027 $ 16,216 $ 16,566 $ 17,245 Total interest expense 2,858 3,203 3,565 4,199 4,492 Net interest income (FTE) $ 13,864 $ 12,824 $ 12,651 $ 12,367 $ 12,753 18 Table of Contents Allowance for Loan and Lease Losses The viability of any financial institution is ultimately determined by its management of credit risk. Loans represent our single largest concentration of risk. The ALLL is our estimation of incurred losses within the existing loan portfolio. We allocate the ALLL throughout the loan portfolio based on our assessment of the underlying risks associated within each loan segment. Our assessments include allocations based on specific impairment valuation allowances, historical charge-offs, internally assigned credit risk ratings, and past due and nonaccrual balances. A portion of the ALLL is not allocated to any one loan segment, but is instead a representation of other qualitative risks that reflect the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio. The following table summarizes our charge-offs, recoveries, provision for loan losses, and ALLL balances as of, and for the unaudited three month periods ended: December 31 2020 September 30 2020 June 30 2020 March 31 2020 December 31 2019 Total charge-offs $ 111 $ 46 $ 66 $ 158 $ 334 Total recoveries 93 159 141 128 122 Net loan charge-offs (recoveries) 18 (113) (75) 30 212 Net loan charge-offs (recoveries) to average loans outstanding — % (0.01) % (0.01) % — % 0.02 % Provision for loan losses $ 256 $ 516 $ 105 $ 788 $ (18) Provision for loan losses to average loans outstanding 0.02 % 0.04 % 0.01 % 0.07 % — % ALLL $ 9,744 $ 9,506 $ 8,877 $ 8,697 $ 7,939 ALLL as a % of loans at end of period 0.79 % 0.73 % 0.69 % 0.74 % 0.67 % The following table summarizes our charge-off and recovery activity for the years ended December 31: 2020 2019 2018 2017 2016 ALLL at beginning of period $ 7,939 $ 8,375 $ 7,700 $ 7,400 $ 7,400 Charge-offs Commercial 7 143 575 263 57 Agricultural 24 240 51 2 — Residential real estate 28 99 151 200 574 Consumer 322 466 324 306 285 Total charge-offs 381 948 1,101 771 916 Recoveries Commercial 149 123 325 449 445 Agricultural 39 3 3 4 95 Residential real estate 136 189 261 206 287 Consumer 197 167 209 159 224 Total recoveries 521 482 798 818 1,051 Provision for loan losses 1,665 30 978 253 (135) ALLL at end of period $ 9,744 $ 7,939 $ 8,375 $ 7,700 $ 7,400 Net loan charge-offs (recoveries) $ (140) $ 466 $ 303 $ (47) $ (135) Net loan charge-offs (recoveries) to average loans outstanding (0.01) % 0.04 % 0.03 % — % (0.01) % ALLL as a % of loans at end of period 0.79 % 0.67 % 0.74 % 0.71 % 0.73 % While we have experienced fluctuations in credit quality indicators in recent periods, credit quality remained strong at December 31, 2020. The COVID-19 pandemic led to some temporary and permanent closures of businesses throughout the communities in which we serve, which resulted in increased unemployment. We increased the ALLL during the year as a result of increased economic and environmental related risk factors, primarily driven by COVID-19. 19 Table of Contents The economic impact from the COVID-19 pandemic could pose significant credit risk due to the potential inability of consumer and commercial borrowers to make contractual payments. In late March 2020, we implemented payment programs for borrowers to alleviate the financial setback due to the temporary closure of businesses and lost wages. These programs, along with the SBA PPP, could mask or delay the detection and reporting of deterioration in credit quality indicators. We continue to monitor the economic impact from COVID-19 as it relates to credit risk to ensure the ALLL is appropriate. The following table illustrates the two main components of the ALLL as of: December 31 2020 September 30 2020 June 30 2020 March 31 2020 December 31 2019 ALLL Individually evaluated for impairment $ 911 $ 869 $ 950 $ 1,309 $ 1,114 Collectively evaluated for impairment 8,833 8,637 7,927 7,388 6,825 Total $ 9,744 $ 9,506 $ 8,877 $ 8,697 $ 7,939 ALLL to gross loans Individually evaluated for impairment 0.07 % 0.07 % 0.07 % 0.11 % 0.09 % Collectively evaluated for impairment 0.72 % 0.66 % 0.62 % 0.63 % 0.58 % Total 0.79 % 0.73 % 0.69 % 0.74 % 0.67 % While we utilize our best judgment and information available, the ultimate adequacy of the ALLL is dependent upon a variety of factors beyond our control, including the performance of our borrowers, the economy, and changes in interest rates. We closely monitor overall credit quality indicators and our policies and procedures related to the analysis of the ALLL to ensure that the ALLL remains at an appropriate level. For further discussion of the allocation of the ALLL, see “Note 4 – Loans and ALLL” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data. Loans Past Due and Loans in Nonaccrual Status Fluctuations in past due and nonaccrual status loans can have a significant impact on the ALLL. To determine the potential impact, and corresponding estimated losses, we analyze our historical loss trends on loans past due greater than 30 days and nonaccrual status loans for indications of additional deterioration. Total Past Due and Nonaccrual Loans as of December 31 2020 2019 2018 2017 2016 Commercial $ 2,148 $ 2,477 $ 2,722 $ 2,518 $ 3,347 Agricultural 3,786 4,285 5,377 2,367 1,251 Residential real estate 3,580 4,572 3,208 4,881 2,716 Consumer 96 71 105 70 115 Total $ 9,610 $ 11,405 $ 11,412 $ 9,836 $ 7,429 Total past due and nonaccrual loans to gross loans 0.78 % 0.96 % 1.01 % 0.90 % 0.74 % Past due and nonaccrual status loans, as a percentage of gross loans, have improved over the last year and continue to be at low levels as a result of strong repayment performance. A summary of loans past due and in nonaccrual status, including the composition of the ending balance of nonaccrual status loans by type, is included in “Note 4 – Loans and ALLL” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data. 20 Table of Contents Troubled Debt Restructurings We have taken a proactive approach to modifying loans to assist borrowers who are willing to work with us, thus making them less likely to default, and to avoid foreclosure. This approach has permitted certain borrowers to develop a payment structure that will allow them to continue making payments in lieu of foreclosure. Modifications have been successful for us and our customers as very few of the modified loans have resulted in foreclosures. The majority of new modifications result in terms that satisfy our criteria for continued interest accrual. TDRs that have been placed in nonaccrual status may be placed back on accrual status after six months of continued performance and achievement of current payment status. We restructure debt with borrowers who due to financial difficulties are unable to service their debt under the original terms. We may extend the amortization period, reduce interest rates, allow temporary interest-only payment structures, forgive principal, forgive interest, or grant a combination of these modifications. Typically, the modifications are for a period of three years or less. There were no TDRs that were government sponsored as of December 31, 2020 or December 31, 2019. Losses associated with TDRs, if any, are included in the estimation of the ALLL during the quarter in which a loan is identified as a TDR, and we review the analysis of the ALLL estimation each reporting period thereafter to ensure its continued appropriateness. The following table provides a roll-forward of TDRs for the years ended December 31, 2019 and 2020: Accruing Interest Nonaccrual Total Number of Loans Balance Number of Loans Balance Number of Loans Balance January 1, 2019 133 $ 23,400 28 $ 3,551 161 $ 26,951 New modifications 11 4,491 — — 11 4,491 Principal advances (payments) — (1,295) — (382) — (1,677) Loans paid off (25) (3,319) (15) (1,596) (40) (4,915) Partial charge-offs — — — (65) — (65) Transfers to OREO — — (1) (48) (1) (48) Transfers to accrual status 9 1,219 (9) (1,219) — — Transfers to nonaccrual status (6) (3,302) 6 3,302 — — December 31, 2019 122 21,194 9 3,543 131 24,737 New modifications 15 7,909 3 645 18 8,554 Principal advances (payments) — (1,690) — (148) — (1,838) Loans paid off (30) (5,317) (2) (850) (32) (6,167) Partial charge-offs — — — — — — Transfers to OREO — — (2) (356) (2) (356) Transfers to accrual status 1 104 (1) (104) — — Transfers to nonaccrual status — — — — — — December 31, 2020 108 $ 22,200 7 $ 2,730 115 $ 24,930 21 Table of Contents The following table summarizes our TDRs as of December 31: 2020 2019 2018 Accruing Interest Nonaccrual Total Accruing Interest Nonaccrual Total Accruing Interest Nonaccrual Total Current $ 22,017 $ 2,421 $ 24,438 $ 20,847 $ 507 $ 21,354 $ 21,794 $ 2,673 $ 24,467 Past due 30-59 days 183 — 183 346 — 346 899 — 899 Past due 60-89 days — — — 1 — 1 707 — 707 Past due 90 days or more — 309 309 — 3,036 3,036 — 878 878 Total $ 22,200 $ 2,730 $ 24,930 $ 21,194 $ 3,543 $ 24,737 $ 23,400 $ 3,551 $ 26,951 2017 2016 Accruing Interest Nonaccrual Total Accruing Interest Nonaccrual Total Current $ 21,234 $ — $ 21,234 $ 17,557 $ 559 $ 18,116 Past due 30-59 days 1,778 805 2,583 2,898 230 3,128 Past due 60-89 days 219 708 927 138 — 138 Past due 90 days or more 53 1,400 1,453 — — — Total $ 23,284 $ 2,913 $ 26,197 $ 20,593 $ 789 $ 21,382 Additional disclosures about TDRs are included in “Note 4 – Loans and ALLL” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data. Impaired Loans The following is a summary of information pertaining to impaired loans as of December 31: 2020 2019 Recorded Balance Unpaid Principal Balance Valuation Allowance Recorded Balance Unpaid Principal Balance Valuation Allowance TDRs Commercial real estate $ 4,915 $ 5,169 $ 79 $ 5,325 $ 5,643 $ 15 Commercial other 3,567 3,567 5 1,156 1,156 — Agricultural real estate 9,667 9,667 54 9,182 9,181 12 Agricultural other 2,903 2,903 2 4,421 4,421 14 Residential real estate senior liens 3,878 4,073 692 4,641 4,923 922 Home equity lines of credit — — — 12 312 — Total TDRs 24,930 25,379 832 24,737 25,636 963 Other impaired loans Commercial real estate 139 201 — 153 216 — Commercial other 1,200 1,200 — 1,231 1,231 — Agricultural real estate 1,008 1,058 — 699 750 — Agricultural other 218 218 — 538 538 — Residential real estate senior liens 441 588 79 760 907 151 Home equity lines of credit — — — 73 73 — Total other impaired loans 3,006 3,265 79 3,454 3,715 151 Total impaired loans $ 27,936 $ 28,644 $ 911 $ 28,191 $ 29,351 $ 1,114 We continue to devote considerable attention to identifying impaired loans and adjusting the net carrying value of these loans to their current net realizable values through the establishment of a specific reserve or the recording of a charge-off. 22 Table of Contents Additional disclosures related to impaired loans are included in “Note 4 – Loans and ALLL” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data. Nonperforming Assets The following table summarizes our nonperforming assets as of December 31: 2020 2019 2018 2017 2016 Nonaccrual status loans $ 5,313 $ 6,535 $ 7,260 $ 3,027 $ 1,060 Accruing loans past due 90 days or more — — 113 395 633 Total nonperforming loans 5,313 6,535 7,373 3,422 1,693 Foreclosed assets 527 456 355 291 231 Debt securities 230 230 230 230 230 Total nonperforming assets $ 6,070 $ 7,221 $ 7,958 $ 3,943 $ 2,154 Nonperforming loans as a % of total loans 0.43 % 0.55 % 0.65 % 0.31 % 0.17 % Nonperforming assets as a % of total assets 0.31 % 0.40 % 0.42 % 0.20 % 0.11 % The accrual of interest on commercial and agricultural loans, as well as residential real estate loans, is discontinued at the time a loan is 90 days or more past due unless the credit is well-secured and in the process of short-term collection. Upon transferring a loan to nonaccrual status, we perform an evaluation to determine the net realizable value of the underlying collateral. This evaluation is used to help determine if a charge-off is necessary. Consumer loans are typically charged-off no later than 180 days past due. Loans may be placed back on accrual status after six months of continued performance and achievement of current payment status. While the level of nonperforming loans has fluctuated in recent periods, it remains low in comparison to peer banks. The following table summarizes nonaccrual loans as of December 31: 2020 2019 2018 2017 2016 Commercial $ 1,329 $ 1,621 $ 1,757 $ 729 $ 4 Agricultural 3,785 4,285 4,949 1,950 533 Residential real estate 199 629 554 348 523 Total $ 5,313 $ 6,535 $ 7,260 $ 3,027 $ 1,060 Included in the nonaccrual loan balances above were loans also classified as TDR as of December 31: 2020 2019 2018 2017 2016 Commercial $ 129 $ 390 $ 160 $ 729 $ — Agricultural 2,559 3,048 3,391 1,950 405 Residential real estate 42 105 — 234 384 Total $ 2,730 $ 3,543 $ 3,551 $ 2,913 $ 789 Additional disclosures about nonaccrual status loans are included in “Note 4 – Loans and ALLL”of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data. 23 Table of Contents Noninterest Income and Noninterest Expenses Significant noninterest income balances are highlighted in the following table for the years ended December 31: Change Change 2020 2019 $ % 2018 $ % Service charges and fees ATM and debit card fees $ 3,723 $ 3,239 $ 484 14.94 % $ 2,888 $ 351 12.15 % Service charges and fees on deposit accounts 1,847 2,328 (481) (20.66) % 2,276 52 2.28 % Freddie Mac servicing fee 625 626 (1) (0.16) % 651 (25) (3.84) % Net OMSR income (loss) 44 (170) 214 N/M 25 (195) (780.00) % Other fees for customer services 305 324 (19) (5.86) % 370 (46) (12.43) % Total service charges and fees 6,544 6,347 197 3.10 % 6,210 137 2.21 % Net gain on sale of mortgage loans 2,716 650 2,066 317.85 % 525 125 23.81 % Wealth management fees 2,578 2,792 (214) (7.66) % 2,836 (44) (1.55) % Gains from redemption of corporate owned life insurance policies 891 — 891 N/M — — — % Earnings on corporate owned life insurance policies 755 764 (9) (1.18) % 742 22 2.96 % Net income (loss) on joint venture investment 577 (3,108) 3,685 N/M 274 (3,382) N/M Other 362 594 (232) (39.06) % 394 200 50.76 % Total noninterest income $ 14,423 $ 8,039 $ 6,384 79.41 % $ 10,981 $ (2,942) (26.79) % Significant changes in noninterest income are detailed below: ATM and debit card fees fluctuate from period to period based primarily on their usage. While we do not anticipate significant changes to our ATM and debit card fee structure, we do expect that fee income will continue to increase in 2021 as the usage of ATM and debit cards continues to increase. Service charges and fees on deposit accounts declined in 2020 as a result of waived fees. In response to COVID-19, which has led to an increase in the need for electronic services and products, we elected to temporarily waive certain charges and fees, and permanently remove some charges and fees, to ease the financial stress of our customers. As such, we expect service charges and fees in 2021 to approximate 2020 levels. OMSR income results are driven, in part, by changes in offering rates on residential mortgage loans, anticipated prepayments in the servicing-retained portfolio, and the volume of loans within the servicing-retained portfolio. Increased prepayment speeds, as a result of a decline in interest rates during the first quarter of 2020, were the primary driver of the losses recognized during the first half of 2020. During the second half of 2020, the volume of loans serviced increased which resulted in an increase in the value of the servicing rights. OMSR income during 2021 may continue to experience fluctuations and could vary from 2020 levels. Net gain on sale of mortgage loans fluctuates as the result of a change in the amount of loans sold and pricing. The amount of loans sold is driven by customer demand and balance sheet management strategies. We experienced a significant increase in loan demand during 2020 which led to an increase in the number and dollar amount of loans sold during the year. As such, net gain on sale of mortgage loans increased significantly. As demand is expected to slow during 2021, net gain on sale of mortgage loans is not expected to exceed 2020 levels. The decrease in wealth management fees, primarily during the first quarter of 2020, was driven by a decline in the stock market causing the value of investment assets under management to decrease. While strategic additions in staffing have already led to new business within Isabella Wealth, wealth management fees during 2021 may not exceed 2020 levels due to the uncertainty in the stock market as a result of COVID-19. We recognized income during 2020 due to the redemption of corporate owned life insurance policies in connection with the passing of three retired bank employees. 24 Table of Contents We sold our membership interest in our joint venture investment in CSS during the fourth quarter of 2020, which resulted in a $394 reduction in income. As a result of a valuation during the fourth quarter of 2019, CSS recognized a $7,133 impairment related to intangible assets as of December 31, 2019. Since we accounted for our investment in CSS under the equity method of accounting, we reduced our investment in CSS by $3,566 during the fourth quarter of 2019. The fluctuations in all other income are spread throughout various categories, none of which are individually significant. Significant noninterest expense balances are highlighted in the following table for the years ended December 31: Change Change 2020 2019 $ % 2018 $ % Compensation and benefits $ 23,772 $ 23,205 $ 567 2.44 % $ 22,609 $ 596 2.64 % Losses on extinguishment of debt 7,643 — 7,643 N/M — — — % Furniture and equipment 5,787 5,866 (79) (1.35) % 6,055 (189) (3.12) % Occupancy 3,557 3,418 139 4.07 % 3,263 155 4.75 % Other Audit, consulting, and legal fees 1,836 1,884 (48) (2.55) % 2,222 (338) (15.21) % ATM and debit card fees 1,441 1,210 231 19.09 % 1,036 174 16.80 % Marketing costs 877 762 115 15.09 % 596 166 27.85 % Loan underwriting fees 825 905 (80) (8.84) % 1,016 (111) (10.93) % Donations and community relations 723 1,026 (303) (29.53) % 710 316 44.51 % Director fees 695 788 (93) (11.80) % 858 (70) (8.16) % FDIC insurance premiums 612 211 401 190.05 % 726 (515) (70.94) % All other 3,465 3,775 (310) (8.21) % 3,761 14 0.37 % Total other 10,474 10,561 (87) (0.82) % 10,925 (364) (3.33) % Total noninterest expenses $ 51,233 $ 43,050 $ 8,183 19.01 % $ 42,852 $ 198 0.46 % Significant changes in noninterest expenses are detailed below: During the fourth quarter of 2020, we incurred expense of $7,643 as a result of the extinguishment of $100,000 of FHLB advances. Audit, consulting, and legal fees in 2018 included one-time charges related to income tax strategies. As a result, 2020 and 2019 expenses were less than 2018 expenses. We have experienced increased usage of ATM and debit cards which has resulted in increased income and also increased ATM and debit card expenses. Based on the anticipated continuation of increased ATM and debit card usage, we expect expenses to increase in 2021. Loan underwriting fees increased during the second half of 2018 and continued in the first quarter of 2019 as a result of new loan products, including first time home buyer and down payment assistance programs designed to generate residential mortgage growth. Loan underwriting fees in 2019 did not exceed 2018 levels based on the nature of products offered during 2019. Additionally, loan underwriting fees in 2020 did not exceed 2019 levels. Fees in 2021 are expected to approximate 2020 levels. Donations and community relations increased during 2019 as a result of initiatives designed to deepen and strengthen our relationship with the communities in which we operate and serve. In addition to providing monetary contributions, some of these initiatives include volunteering our time, which is not a component of donations and community relations costs. Government restrictions and temporary business closures related to COVID-19 impacted our ability to maintain their level of support in 2020. Donations and community relations is expected to approximate 2020 levels in 2021. As a result of an assessment credit of $440 received during the third quarter of 2019, FDIC insurance premiums declined in 2019 as compared to 2020 and 2018 expenses. FDIC insurance premiums in 2021 are expected to approximate 2020 levels. 25 Table of Contents All other expenses declined during 2020 primarily as a result of reduced employee education and travel expenses. Due to COVID-19, many events were cancelled or offered at no cost. While education and travel expenses in 2021 are expected to exceed 2020 levels, expenses are not expected to resume normal levels and as a result, total all other expenses are not expected to resume normal levels. The fluctuations in all other expenses are spread throughout various categories, none of which are individually significant. Analysis of Changes in Financial Condition The following table shows the composition and changes in our balance sheet as of December 31: Change 2020 2019 $ % ASSETS Cash and cash equivalents $ 246,640 $ 60,572 $ 186,068 N/M AFS securities Amortized cost of AFS securities 325,966 423,980 (98,014) (23.12) % Unrealized gains (losses) on AFS securities 13,262 5,859 7,403 126.35 % AFS securities 339,228 429,839 (90,611) (21.08) % Mortgage loans AFS 2,741 904 1,837 N/M Loans Gross loans 1,238,311 1,186,570 51,741 4.36 % Less allowance for loan and lease losses 9,744 7,939 1,805 22.74 % Net loans 1,228,567 1,178,631 49,936 4.24 % Premises and equipment 25,140 26,242 (1,102) (4.20) % Corporate owned life insurance policies 28,292 28,455 (163) (0.57) % Accrued interest receivable 6,882 6,501 381 5.86 % Equity securities without readily determinable fair values 17,383 21,629 (4,246) (19.63) % Goodwill and other intangible assets 48,331 48,379 (48) (0.10) % Other assets 14,174 11,491 2,683 23.35 % TOTAL ASSETS $ 1,957,378 $ 1,812,643 $ 144,735 7.98 % LIABILITIES AND SHAREHOLDERS’ EQUITY Liabilities Deposits $ 1,566,317 $ 1,313,851 $ 252,466 19.22 % Borrowed funds 158,747 275,999 (117,252) (42.48) % Accrued interest payable and other liabilities 13,726 12,611 1,115 8.84 % Total liabilities 1,738,790 1,602,461 136,329 8.51 % Shareholders’ equity 218,588 210,182 8,406 4.00 % TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY $ 1,957,378 $ 1,812,643 $ 144,735 7.98 % A discussion of changes in balance sheet amounts by major categories follows: Cash and cash equivalents Included in cash and cash equivalents are funds held with the FRB which fluctuate from period to period. Cash levels increased significantly during 2020 as a result of increased monthly prepayments and payoffs of AFS securities, funding from the SBA for PPP loan forgiveness, and an increase in customer deposits. During 2020, excess funds were used to pay maturing long-term borrowings, extinguish long-term borrowings, and pay other short-term liabilities. Payments for maturing borrowings is expected to continue in 2021. 26 Table of Contents AFS securities The primary objective of our investing activities is to provide for safety of the principal invested. Secondary considerations include providing earnings and liquidity while managing our overall exposure to changes in interest rates. Over the last two years, the flat yield curve encouraged the use of excess funds to reduce higher-cost borrowings as opposed to investing in AFS securities. However, based on balance sheet strategies, excess funds above what is required to retire higher-cost funding sources may prudently be deployed to purchase of AFS securities in future periods. The following is a schedule of the carrying value of AFS securities as of December 31: 2020 2019 2018 Government sponsored enterprises $ — $ — $ 170 States and political subdivisions 143,656 169,752 190,866 Auction rate money market preferred 3,237 3,119 2,554 Mortgage-backed securities 88,652 140,204 184,484 Collateralized mortgage obligations 101,983 116,764 116,760 Corporate 1,700 — — Total $ 339,228 $ 429,839 $ 494,834 Excluding those holdings in government sponsored enterprises and municipalities within the State of Michigan, there were no investments in securities of any one issuer that exceeded 10% of shareholders’ equity during 2020, 2019, and 2018. We have a policy prohibiting investments in securities that we deem unsuitable due to their inherent credit or market risks. Prohibited investments include stripped mortgage-backed securities, zero coupon bonds, nongovernment agency asset-backed securities, and structured notes. Our holdings in mortgage-backed securities and collateralized mortgage obligations include only government agencies and government sponsored agencies as we hold no investments in private label mortgage-backed securities or collateralized mortgage obligations. The following is a schedule of maturities of AFS securities and their weighted average yields as of December 31, 2020. Weighted average yields have been computed on an FTE basis using a tax rate of 21%. Our auction rate money market preferred investments are long-term floating rate instruments. The issuers of auction rate securities generally have the right to redeem or refinance the debt. Because of their lack of contractual maturities, auction rate money market preferred stocks are not reported by a specific maturity group. Mortgage-backed securities and collateralized mortgage obligations are not reported by a specific maturity group due to their variable monthly payments. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations. Maturing Within One Year After One Year But Within Five Years After Five Years But Within Ten Years After Ten Years Securities with Variable Monthly Payments or Noncontractual Maturities Amount Yield (%) Amount Yield (%) Amount Yield (%) Amount Yield (%) Amount Yield (%) States and political subdivisions $ 23,922 2.36 $ 65,462 3.25 $ 25,290 3.97 $ 28,982 3.69 $ — — Mortgage-backed securities — — — — — — — — 88,652 2.06 Collateralized mortgage obligations — — — — — — — — 101,983 2.28 Auction rate money market preferred — — — — — — — — 3,237 6.27 Corporate — — — — 1,700 5.00 — — — — Total $ 23,922 2.36 $ 65,462 3.25 $ 26,990 4.04 $ 28,982 3.69 $ 193,872 2.25 27 Table of Contents Loans Loans are the largest component of earning assets. The proper management of credit and market risk inherent in the loan portfolio is critical to our financial stability. To control these risks, we have adopted strict underwriting standards, lending limits to a single borrower, loan to collateral value limits, and a defined market area. We also monitor and limit loan concentrations to specific industries. We have no foreign loans and there were no concentrations greater than 10% of total loans that are not disclosed as a separate category in the following table. The following table presents the composition of the loan portfolio for the years ended December 31: 2020 2019 2018 2017 2016 Commercial $ 756,686 $ 700,941 $ 659,529 $ 634,759 $ 575,664 Agricultural 100,461 116,920 127,161 128,269 126,492 Residential real estate 307,543 298,569 275,343 272,368 266,050 Consumer 73,621 70,140 66,674 56,123 42,409 Total $ 1,238,311 $ 1,186,570 $ 1,128,707 $ 1,091,519 $ 1,010,615 The following table presents the change in the loan portfolio categories for the years ended December 31: 2020 2019 2018 $ Change % Change $ Change % Change $ Change % Change Commercial $ 55,745 7.95 % $ 41,412 6.28 % $ 24,770 3.90 % Agricultural (16,459) (14.08) % (10,241) (8.05) % (1,108) (0.86) % Residential real estate 8,974 3.01 % 23,226 8.44 % 2,975 1.09 % Consumer 3,481 4.96 % 3,466 5.20 % 10,551 18.80 % Total $ 51,741 4.36 % $ 57,863 5.13 % $ 37,188 3.41 % Loan demand has been negatively impacted by the pandemic and competition for new commercial loan opportunities continues to be strong. Growth in the commercial loan portfolio during 2020 was driven by SBA PPP loans. While we expect loan forgiveness on the remaining SBA PPP loans during 2021, we are still expecting overall growth during 2021 within the commercial portfolio as we continue to provide attractive and competitive loan products. Agricultural loans continued to decline in 2020 due to the competitive environment. Residential real estate and consumer loans have experienced growth over the last year and continued growth is expected in 2021. Equity securities without readily determinable fair values Included in equity securities without readily determinable fair values are restricted securities, which are carried at cost, and our joint venture investment in CSS accounted for under the equity method of accounting. We sold our membership interest in CSS during the fourth quarter of 2020, which reduced equity securities without readily determinable fair values $4,246 when compared to December 31, 2019. For more information related to this investment, refer to “Note 1 – Nature of Operations and Summary of Significant Accounting Policies”, “Note 6 – Investment in Joint Venture”, and “Note 18 – Fair Value” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data. Goodwill and other intangible assets Goodwill represents the excess of the amounts paid to acquire subsidiaries over the fair value of their net assets at the date of acquisition. The majority of the recorded goodwill is related to acquisitions of other banks, which were subsequently merged into Isabella Bank. If it is determined that the goodwill is impaired, a write-down of goodwill by the amount of the impairment would be required. The decline in economic conditions, as a result of the COVID-19 pandemic and other factors, led to a significant decline in the stock market causing the value of investments, including our stock, to decline. Our stock price was negatively impacted in March 2020, which continued during most of 2020. Since the price of our stock increased but had not fully recovered through the fourth quarter, we decided to engage a reputable, third-party valuation firm to perform a quantitative analysis of goodwill as of December 31 , 2020. In determining the fair value of the Bank and Isabella Bank Corporation, the third-party firm assessed general economic conditions, industry and market considerations, the impact of recent events to financial performance, the market price of our common stock, and other relevant events. Based on the valuation prepared, it was determined that our 28 Table of Contents estimated fair values of the Bank and Isabella Bank Corporation at Dece mber 31, 2020 were greater than our recorded book value and no impairment of goodwill was identified. Furthermore, management noted that despite the decline of the market capitalization as a result of the COVID-19 pandemic, our financial performance remained positive. This is evidenced by our financial results, strong credit quality indicators, increased liquidity position, as well as the strong capital position. Finally, by the end of the fourth quarter, our stock price had increased to levels consistent with prices prior to the second quarter of 2020. Based on these factors and the results of the independent quantitative analysis of goodwill, management concluded that it was more likely than not that there was no goodwill impairment as of December 31, 2020. Other assets Other assets consist primarily of prepaid expenses, OMSR, receivables, and net deferred tax assets. As a result of the sale in our joint venture investment in CSS, we recorded a $3,227 receivable related to this transaction. For more information related to estimates and deferred taxes, refer to “Note 1 – Nature of Operations and Summary of Significant Accounting Policies” and “Note 16 – Federal Income Taxes” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data. Deposits Deposits are our primary source of funding. The following table presents the composition of the deposit portfolio as of December 31: 2020 2019 2018 Noninterest bearing demand deposits $ 375,395 $ 249,152 $ 236,534 Interest bearing demand deposits 302,444 229,865 235,287 Savings deposits 505,497 427,215 387,252 Certificates of deposit 358,165 365,049 358,127 Brokered certificates of deposit 14,029 27,458 62,148 Internet certificates of deposit 10,787 15,112 13,345 Total $ 1,566,317 $ 1,313,851 $ 1,292,693 The following table presents the change in the deposit categories for the years ended December 31: 2020 2019 $ Change % Change $ Change % Change Noninterest bearing demand deposits $ 126,243 50.67 % $ 12,618 5.33 % Interest bearing demand deposits 72,579 31.57 % (5,422) (2.30) % Savings deposits 78,282 18.32 % 39,963 10.32 % Certificates of deposit (6,884) (1.89) % 6,922 1.93 % Brokered certificates of deposit (13,429) (48.91) % (34,690) (55.82) % Internet certificates of deposit (4,325) (28.62) % 1,767 13.24 % Total $ 252,466 19.22 % $ 21,158 1.64 % Total deposits have increased over the past 12 months with significant growth in non-contractual deposits, such as demand and savings deposits. This trend is anticipated to continue during 2021 as the financial markets continue to exhibit significant signs of instability. Additionally, government stimulus programs have driven growth in deposits. We experienced a decline in certificates of deposit over the past year as a result of the low interest rate environment. Brokered certificates of deposit offer another source of funding and may fluctuate from period to period based on our funding needs, including changes in assets such as loans and investments. During 2019 and 2020, we used excess funds to reduce higher-cost deposits, such as brokered certificates of deposit. This trend is expected to continue into 2021. 29 Table of Contents The remaining maturity of certificates of deposit of $250 or more as of December 31, 2020 was as follows: Maturity Within 3 months $ 43,687 Within 3 to 6 months 6,257 Within 6 to 12 months 28,064 Over 12 months 29,184 Total $ 107,192 Borrowed Funds Borrowed funds include FHLB advances, securities sold under agreements to repurchase, and federal funds purchased. The balance of borrowed funds fluctuates from period to period based on our funding needs that arise from changes in loans, investments, and deposits. To provide balance sheet growth, we may utilize borrowings and brokered deposits to fund earning assets. The following table presents borrowed funds balances for the years ended December 31: 2020 2019 2018 FHLB advances $ 90,000 $ 245,000 $ 300,000 Securities sold under agreements to repurchase without stated maturity dates 68,747 30,999 40,299 Total $ 158,747 $ 275,999 $ 340,299 During the fourth quarter of 2020, we elected to extinguish $100,000 of FHLB advances based on our level of cash reserves and strategic initiatives. Due to a significant increase in deposit accounts during the fourth quarter of 2020, our level of securities sold under agreements to repurchase increased as of December 31, 2020. We believe this to be a short-term increase and expect the balance of securities sold under agreements to repurchase to decline in the first half of 2021. We had no fed funds purchased for the years ended December 31, 2020, 2019, or 2018. For additional disclosure related to borrowed funds, see “Note 9 – Borrowed Funds” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data. Accrued interest payable and other liabilities Included in accrued interest payable and other liabilities are obligations related to our defined benefit pension plan and other employee benefits. For more information on the defined benefit pension plan and other employee benefits, see “Note 13 – Benefit Plans” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data. Contractual Obligations and Loan Commitments We have various financial obligations, including contractual obligations and commitments related to deposits and borrowings, which may require future cash payments. We also have loan related commitments that may impact liquidity. The commitments include unused lines of credit, commercial and standby letters of credit, and commitments to grant loans. These commitments to grant loans include residential mortgage loans with the majority committed to be sold to the secondary market. Many of these commitments historically have expired without being drawn upon and do not necessarily represent our future cash requirements. For additional disclosure related to Contractual Obligations and Loan Commitments, see “Note 10 – Off-Balance-Sheet Activities, Commitments and Other Matters” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data. 30 Table of Contents Capital Capital consists solely of common stock, retained earnings, and accumulated other comprehensive income (loss). We are authorized to raise capital through dividend reinvestment, employee and director stock purchases, and shareholder stock purchases. Pursuant to these authorizations, we issued 231,393 shares or $4,185 of common stock during 2020, and 209,583 shares or $4,876 of common stock in 2019. We offer the Directors Plan in which participants purchase stock units through deferred fees, in lieu of cash payments. Pursuant to this plan, we increased shareholders’ equity by $413 and $523 during 2020 and 2019, respectively. We also grant restricted stock awards pursuant to the RSP, effective June 24, 2020. Pursuant to this plan, we increased shareholders’ equity by $14 during 2020. We have a publicly announced common stock repurchase plan. Pursuant to this plan, we repurchased 144,950 shares or $2,702 of common stock during 2020 and 169,748 shares or $4,003 during 2019. As of December 31, 2020, we were authorized to repurchase up to an additional 102,956 shares of common stock. The FRB has established minimum risk-based capital guidelines. Pursuant to these guidelines, a framework has been established that assigns risk weights to each category of on and off-balance-sheet items to arrive at risk adjusted total assets. Regulatory capital is divided by the risk adjusted assets with the resulting ratio compared to the minimum standard to determine whether a corporation has adequate capital. The common equity tier 1 capital ratio has a minimum requirement of 4.50%. The minimum standard for primary, or Tier 1 capital is 6.00% and the minimum standard for total capital is 8.00%. The minimum requirements presented below include the minimum required capital levels based on the Basel III Capital Rules. Capital requirements to be considered well capitalized are based upon prompt corrective action regulations, as amended to reflect the changes under the Basel III Capital Rules. The following table sets forth these requirements and our ratios as of December 31: 2020 2019 Actual Minimum Required - BASEL III Required to be Considered Well Capitalized Actual Minimum Required - BASEL III Required to be Considered Well Capitalized Common equity tier 1 capital 12.97 % 7.000 % 6.500 % 12.56 % 7.000 % 6.500 % Tier 1 capital 12.97 % 8.500 % 8.000 % 12.56 % 8.500 % 8.000 % Total capital 13.75 % 10.500 % 10.000 % 13.18 % 10.500 % 10.000 % Tier 1 leverage 8.37 % 4.000 % 5.000 % 9.01 % 4.000 % 5.000 % There are no significant regulatory constraints placed on our capital. At December 31, 2020, the Bank exceeded minimum capital requirements. For further information regarding the Bank’s capital requirements, see “Note 11 – Minimum Regulatory Capital Requirements” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data. Fair Value We utilize fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. AFS securities, cash flow hedge derivative instruments and certain liabilities are recorded at fair value on a recurring basis. Additionally, from time to time, we may be required to record at fair value other assets on a nonrecurring basis, such as mortgage loans AFS, impaired loans, goodwill, foreclosed assets, OMSR, and certain other assets and liabilities. These nonrecurring fair value adjustments typically involve the application of lower of cost or market accounting or write downs of individual assets. For further information regarding fair value measurements, see “Note 1 – Nature of Operations and Summary of Significant Accounting Policies” and “Note 18 – Fair Value” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data. Liquidity Liquidity is monitored regularly by our ALCO, which consists of members of senior management. The committee reviews projected cash flows, key ratios, and liquidity available from both primary and secondary sources. Our primary sources of liquidity are cash and cash equivalents and unencumbered AFS securities. These categories totaled $444,051 or 22.69% of assets as of December 31, 2020 as compared to $291,190 or 16.06% as of December 31, 2019. The increase in both the amount and percentage of primary liquidity is a direct result of an increase in market deposits and a 31 Table of Contents deliberate reduction in non-market funding which required collateralization. Liquidity is important for financial institutions because of their need to meet loan funding commitments, depositor withdrawal requests, and various other commitments including expansion of operations, investment opportunities, and payment of cash dividends. Based on these same factors, daily liquidity could vary significantly. Deposit accounts are our primary source of funds. Our secondary sources include the ability to borrow from the FHLB, from the FRB, and through various correspondent banks in the form of federal funds purchased and a line of credit. These funding methods typically carry a higher interest rate than traditional market deposit accounts. In recent periods, we have elected to use excess funds and proceeds from the sale of AFS securities to reduce borrowings and other higher-cost funding sources. Some borrowed funds, including FHLB advances, FRB Discount Window advances, and repurchase agreements, require us to pledge assets, typically in the form of AFS securities or loans, as collateral. As of December 31, 2020, we had available lines of credit of $214,625. Our stress testing of liquidity increased during 2020 and continues to evolve due to economic uncertainly as a result of COVID-19. Our liquidity position remained strong at the end of 2020 which is illustrated in the following table: December 31 2020 Total cash and cash equivalents $ 246,640 Available lines of credit Fed funds lines with correspondent banks 93,000 FHLB borrowings 106,638 FRB Discount Window 9,987 Other lines of credit 5,000 Total available lines of credit 214,625 Unencumbered lendable value of FRB collateral, estimated 1 160,000 Total cash and liquidity $ 621,265 (1) Includes estimated unencumbered lendable value of FHLB collateral of $115,000 The following table summarizes our sources and uses of cash for the years ended December 31: 2020 2019 $ Variance Net cash provided by (used in) operating activities $ 21,997 $ 23,303 $ (1,306) Net cash provided by (used in) investing activities 45,133 15,480 29,653 Net cash provided by (used in) financing activities 118,938 (51,682) 170,620 Increase (decrease) in cash and cash equivalents 186,068 (12,899) 198,967 Cash and cash equivalents January 1 60,572 73,471 (12,899) Cash and cash equivalents December 31 $ 246,640 $ 60,572 $ 186,068 Market Risk Our primary market risks are interest rate risk and liquidity risk. IRR is the exposure of our net interest income to changes in interest rates. IRR results from the difference in the maturity or repricing frequency of a financial institution's interest earning assets and its interest bearing liabilities. Managing IRR is the fundamental method by which financial institutions earn income and create shareholder value. Excessive exposure to IRR could pose a significant risk to our earnings and capital. The FRB has adopted a policy requiring banks to effectively manage the various risks that can have a material impact on safety and soundness. The risks include credit, interest rate, liquidity, operational, and reputational. We have policies, procedures, and internal controls for measuring and managing these risks. Specifically, our Funds Management policy and procedures include defining acceptable types and terms of investments and funding sources, liquidity requirements, limits on investments in long-term assets, limiting the mismatch in repricing opportunities of assets and liabilities, and the frequency of measuring and reporting to our Board of Directors. The primary technique to measure IRR is simulation analysis. Simulation analysis forecasts the effects on the balance sheet structure and net interest income under a variety of scenarios that incorporate changes in interest rates, the shape of yield curves, interest rate relationships, loan prepayments, and funding sources. These forecasts are compared against net interest income projected in a stable interest rate environment. While many assets and liabilities reprice either at maturity or in 32 Table of Contents accordance with their contractual terms, several balance sheet components demonstrate characteristics that require an evaluation to more accurately reflect their repricing behavior. Key assumptions in the simulation analysis include prepayments on loans, probable calls of investment securities, changes in market conditions, loan volumes and loan pricing, deposit sensitivity, and customer preferences. These assumptions are inherently uncertain as they are subject to fluctuation and revision in a dynamic rate environment. As a result, the simulation analysis cannot precisely forecast the impact of rising and falling interest rates on net interest income. Actual results will differ from simulated results due to many other factors, including changes in balance sheet components, interest rate changes, changes in market conditions, and management strategies. We regularly monitor our projected net interest income sensitivity to ensure that it remains within established limits. Gap analysis, the secondary method to measure IRR, measures the cash flows and/or the earliest repricing of our interest bearing assets and liabilities. This analysis is useful for measuring trends in the repricing characteristics of the balance sheet. Significant assumptions are required in this process because of the embedded repricing options contained in assets and liabilities. Residential real estate and consumer loans allow the borrower to repay the balance prior to maturity without penalty, while commercial and agricultural loans may have prepayment penalties. The amount of prepayments is dependent upon many factors, including the interest rate of a given loan in comparison to the current offering rates, the level of home sales, and the overall availability of credit in the market place. Generally, a decrease in interest rates will result in an increase in cash flows from these assets. A significant portion of our securities are callable or have prepayment options. The call and prepayment options are more likely to be exercised in a period of decreasing interest rates. Savings and demand accounts may generally be withdrawn on request without prior notice. The timing of cash flows from these deposits is estimated based on historical experience. Certificates of deposit have penalties that discourage early withdrawals. We do not believe there has been a material change in the nature or categories of our primary market risk exposure, or the particular markets that present the primary risk of loss. We do not know of or expect there to be any material change in the general nature of our primary market risk exposure in the near term, and we do not expect to make material changes to our market risk methods in the near term. We may change those methods in the future to adapt to changes in circumstances or to implement new techniques. Gap analysis is also utilized as a method to measure interest rate sensitivity. Interest rate sensitivity is determined by the amount of earning assets and interest bearing liabilities repricing within a specific time period, and their relative sensitivity to a change in interest rates. We strive to achieve reasonable stability in the net interest margin through periods of changing interest rates. One specific focus of interest rate sensitivity is the loan portfolio, primarily with commercial and agricultural loans. The following table shows the maturity of commercial and agricultural loans outstanding at December 31, 2020. Also provided are the amounts due after one year, classified according to the sensitivity to changes in interest rates. 1 Year or Less 1 to 5 Years Over 5 Years Total Commercial and agricultural $ 179,820 $ 374,313 $ 303,014 $ 857,147 Interest sensitivity Loans maturing after one year that have: Fixed interest rates $ 312,450 $ 116,550 Variable interest rates 61,863 186,464 Total $ 374,313 $ 303,014 Our primary market risk exposures related to the COVID-19 pandemic remain uncertain. A review of our market risk methods are ongoing and modeling is incorporating additional assumptions to account for this uncertainty related to this crisis. Repricing, cash flows, and prepayment projections for loans and mortgage-backed securities are not expected to behave as they would be expected to in a more stable interest rate environment. The SBA PPP loan is a new instrument and has payment characteristics that are still uncertain. In late March 2020, we implemented loan repayment programs for customers to alleviate the financial setback caused by the temporary closure of businesses and lost wages. Under these programs, borrowers whose loans were in good standing as of March 1, 2020 could elect to defer full or partial payments for a short period of time. Customer deposit levels may experience unusual fluctuations due to government support programs, customer and business needs, and general money supply. We continue to closely monitor customer and economic indicators to develop more precise market risk assumptions as the economic impact of this crisis begins to reveal itself. Item 7A. Quantitative and Qualitative Disclosures About Market Risk. The information presented in the section captioned “Market Risk” in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations is incorporated herein by reference. 33 Table of Contents