8. ALLOWANCE FOR LOAN LOSSES

The following table summarizes the rollforward of the allowance for loan losses by portfolio segment (in thousands).



	BALANCE AT		CHARGE-				PROVISION		BALANCE AT
	DECEMBER 31, 2018		OFFS		RECOVERIES		(CREDIT)		DECEMBER 31, 2019

Commercial	$	3,057	$	(9)	$	22	$	881	$	3,951
Commercial loans secured by non-owner occupied real estate		3,389		(63)		48		(255)		3,119
Real estate − residential mortgage		1,235		(98)		118		(96)		1,159
Consumer		127		(262)		52		209		126
Allocation for general risk		863		—		-		61		924
Total	$	8,671	$	(432)	$	240	$	800	$	9,279



	BALANCE AT		CHARGE-				PROVISION		BALANCE AT
	DECEMBER 31, 2017		OFFS		RECOVERIES		(CREDIT)		DECEMBER 31, 2018
Commercial	$	4,298	$	(574)	$	31	$	(698)	$	3,057
Commercial loans secured by non-owner occupied real estate		3,666		—		51		(328)		3,389
Real estate − residential mortgage		1,102		(380)		119		394		1,235
Consumer		128		(251)		61		189		127
Allocation for general risk		1,020		—		—		(157)		863
Total	$	10,214	$	(1,205)	$	262	$	(600)	$	8,671



	BALANCE AT		CHARGE-						BALANCE AT
	DECEMBER 31, 2016		OFFS		RECOVERIES		PROVISION		DECEMBER 31, 2017
Commercial	$	4,041	$	(311)	$	27	$	541	$	4,298
Commercial loans secured by non-owner occupied real estate		3,584		(132)		56		158		3,666
Real estate − residential mortgage		1,169		(313)		207		39		1,102
Consumer		151		(172)		120		29		128
Allocation for general risk		987		—		—		33		1,020
Total	$	9,932	$	(928)	$	410	$	800	$	10,214

For 2019, the Company recorded an $800,000 provision expense for loan losses compared to a $600,000 provision recovery for 2018, or an increase of $1.4 million between years. The 2019 provision expense reflects the growth within the loan portfolio and the increase in classified loans. The Company experienced net loan charge-offs of only $192,000, or 0.02% of total loans, in 2019 compared to net loan charge-offs of $943,000, or 0.11% of total loans, in 2018. Overall, the Company continued to maintain strong asset quality as its nonperforming assets totaled $2.3 million, or only 0.26% of total loans, at December 31, 2019.

Specifically, the 2019 provision expense within the commercial segment was driven by the rating downgrade of a $6.5 million performing commercial and industrial loan to substandard as a result of the unexpected death of a borrower. This downgrade caused a $675,000 increase in the fourth quarter 2019 provision expense. This rating action was prudent due to the inherent uncertainties associated with a large estate liquidation. Recent updates related to this loan indicate that the estate is presently illiquid due to holds placed on deposit accounts and significant real estate holdings and other unique assets that will need to be unwound. As such there is heightened risk that this loan may move into non-performing status in 2020 as a result of payment delays.

Additionally, the 2019 provision credit within commercial loans secured by non-owner occupied real estate was driven, primarily, by a relaxation of the economic qualitative factors applied to the Pass rated portion of this loan segment.

For 2018, the Company recorded a $600,000 provision recovery compared to an $800,000 provision for loan losses in 2017, or a decrease of $1.4 million between years. The 2018 provision recovery reflects our overall strong asset quality, reduced loan portfolio balance and the successful workout of several criticized loans. The Company experienced net loan charge-offs of $943,000, or 0.11% of total loans, in 2018 compared to net loan charge-offs of $51,800, or 0.06%, of total loans, in 2017. The higher 2018 net loan charge-offs reflect the final workout of several non-performing loans on which reserves had previously been established. Nonperforming assets totaled $1.4 million, or only 0.16%, of total loans, at December 31, 2018.

The following tables summarize the loan portfolio and allowance for loan loss by the primary segments of the loan portfolio.


	AT DECEMBER 31, 2019
	(IN THOUSANDS)
			COMMERCIAL LOANS
			SECURED BY NON-		REAL ESTATE −
			OWNER OCCUPIED		RESIDENTIAL
Loans:	COMMERCIAL		REAL ESTATE		MORTGAGE		CONSUMER		TOTAL
Individually evaluated for impairment	$	816	$	8	$	—	$	—	$	824
Collectively evaluated for impairment		264,761		363,627		235,239		18,255		881,882
Total loans	$	265,577	$	363,635	$	235,239	$	18,255	$	882,706


	AT DECEMBER 31, 2019
	(IN THOUSANDS)
			COMMERCIAL LOANS						ALLOCATION
			SECURED BY NON-		REAL ESTATE −				FOR
			OWNER OCCUPIED		RESIDENTIAL				GENERAL
Allowance for loan losses:	COMMERCIAL		REAL ESTATE		MORTGAGE		CONSUMER		RISK		TOTAL
Specific reserve allocation	$	84	$	8	$	—	$	—	$	—	$	92
General reserve allocation		3,867		3,111		1,159		126		924		9,187
Total allowance for loan losses	$	3,951	$	3,119	$	1,159	$	126	$	924	$	9,279


	AT DECEMBER 31, 2018
	(IN THOUSANDS)
			COMMERCIAL LOANS
			SECURED BY NON-		REAL ESTATE −
			OWNER OCCUPIED		RESIDENTIAL
Loans:	COMMERCIAL		REAL ESTATE		MORTGAGE		CONSUMER		TOTAL
Individually evaluated for impairment	$	—	$	11	$	—	$	—	$	11
Collectively evaluated for impairment		250,184		356,532		237,964		17,591		862,271
Total loans	$	250,184	$	356,543	$	237,964	$	17,591	$	862,282


	AT DECEMBER 31, 2018
	(IN THOUSANDS)
			COMMERCIAL LOANS						ALLOCATION
			SECURED BY NON-		REAL ESTATE −				FOR
			OWNER OCCUPIED		RESIDENTIAL				GENERAL
Allowance for loan losses:	COMMERCIAL		REAL ESTATE		MORTGAGE		CONSUMER		RISK		TOTAL
Specific reserve allocation	$	—	$	11	$	—	$	—	$	—	$	11
General reserve allocation		3,057		3,378		1,235		127		863		8,660
Total allowance for loan losses	$	3,057	$	3,389	$	1,235	$	127	$	863	$	8,671

The segments of the Company’s loan portfolio are disaggregated into classes that allows management to monitor risk and performance. The loan classes used are consistent with the internal reports evaluated by the Company’s management and Board of Directors to monitor risk and performance within various segments of its loan portfolio. The commercial loan segment includes both the commercial and industrial and the owner occupied commercial real estate loan classes while the remaining segments are not separated into classes as management monitors risk in these loans at the segment level. The residential mortgage loan segment is comprised of first lien amortizing residential mortgage loans and home equity loans secured by residential real estate. The consumer loan segment consists primarily of installment loans and overdraft lines of credit connected with customer deposit accounts.

Management evaluates for possible impairment any individual loan in the commercial or commercial real estate segment that is in nonaccrual status or classified as a Troubled Debt Restructure (TDR). In addition, consumer and residential mortgage loans with a balance of $150,000 or more are evaluated for impairment. Loans are considered to be impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in evaluating impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed.

Once the determination has been made that a loan is impaired, the determination of whether a specific allocation of the allowance is necessary is measured by comparing the recorded investment in the loan to the fair value of the loan using one of three methods: (a) the present value of expected future cash flows discounted at the loan’s effective interest rate; (b) the loan’s observable market price; or (c) the fair value of the collateral less selling costs for collateral dependent loans. The method is selected on a loan-by-loan basis, with management primarily utilizing the fair value of collateral method. The evaluation of the need and amount of a specific allocation of the allowance and whether a loan can be removed from impairment status is made on a quarterly basis. The Company’s policy for recognizing interest income on impaired loans does not differ from its overall policy for interest recognition.

The need for an updated appraisal on collateral dependent loans is determined on a case-by-case basis. The useful life of an appraisal or evaluation will vary depending upon the circumstances of the property and the economic conditions in the marketplace. A new appraisal is not required if there is an existing appraisal which, along with other information, is sufficient to determine a reasonable value for the property and to support an appropriate and adequate allowance for loan losses. At a minimum, annual documented reevaluation of the property is completed by the Bank’s internal Assigned Risk Department to support the value of the property.

When reviewing an appraisal associated with an existing real estate collateral dependent transaction, the Bank’s internal Assigned Risk Department must determine if there have been material changes to the underlying assumptions in the appraisal which affect the original estimate of value. Some of the factors that could cause material changes to reported values include:

the passage of time;

the volatility of the local market;

the availability of financing;

natural disasters;

the inventory of competing properties;

new improvements to, or lack of maintenance of, the subject property or competing properties upon physical inspection by the Bank;

changes in underlying economic and market assumptions, such as material changes in current and projected vacancy, absorption rates, capitalization rates, lease terms, rental rates, sales prices, concessions, construction overruns and delays, zoning changes, etc.; and/or

environmental contamination.

The value of the property is adjusted to appropriately reflect the above listed factors and the value is discounted to reflect the value impact of a forced or distressed sale, any outstanding senior liens, any outstanding unpaid real estate taxes, transfer taxes and closing costs that would occur with sale of the real estate. If the Assigned Risk Department personnel determine that a reasonable value cannot be derived based on available information, a new appraisal is ordered. The determination of the need for a new appraisal, versus completion of a property valuation by the Bank’s Assigned Risk Department personnel rests with the Assigned Risk Department and not the originating account officer.

The following tables present impaired loans by portfolio segment, segregated by those for which a specific allowance was required and those for which a specific allowance was not necessary.


	AT DECEMBER 31, 2019
					IMPAIRED
					LOANS WITH
	IMPAIRED LOANS WITH				NO SPECIFIC
	SPECIFIC ALLOWANCE				ALLOWANCE		TOTAL IMPAIRED LOANS
									UNPAID
	RECORDED		RELATED		RECORDED		RECORDED		PRINCIPAL
	INVESTMENT		ALLOWANCE		INVESTMENT		INVESTMENT		BALANCE
	(IN THOUSANDS)
Commercial	$	816	$	84	$	—	$	816	$	816
Commercial loans secured by non-owner occupied real estate		8		8		—		8		30
Total impaired loans	$	824	$	92	$	—	$	824	$	846


	AT DECEMBER 31, 2018
					IMPAIRED
					LOANS WITH
	IMPAIRED LOANS WITH				NO SPECIFIC
	SPECIFIC ALLOWANCE				ALLOWANCE		TOTAL IMPAIRED LOANS
									UNPAID
	RECORDED		RELATED		RECORDED		RECORDED		PRINCIPAL
	INVESTMENT		ALLOWANCE		INVESTMENT		INVESTMENT		BALANCE
	(IN THOUSANDS)
Commercial loans secured by non-owner occupied real estate	$	11	$	11	$	—	$	11	$	33
Total impaired loans	$	11	$	11	$	—	$	11	$	33

The following table presents the average recorded investment in impaired loans and related interest income recognized for the periods indicated.


	YEAR ENDED DECEMBER 31,
	2019		2018		2017
	(IN THOUSANDS)
Average impaired balance:
Commercial	$	597	$	228	$	1,075
Commercial loans secured by non-owner occupied real estate		10		12		838
Average investment in impaired loans	$	607	$	240	$	1,913
Interest income recognized:
Commercial	$	30	$	—	$	12
Commercial loans secured by non-owner occupied real estate		—		—		—
Interest income recognized on a cash basis on impaired loans	$	30	$	—	$	12

Management uses a nine-point internal risk rating system to monitor the credit quality of the overall loan portfolio. The first six categories are considered not criticized. The first five “Pass” categories are aggregated, while the Pass‑6, Special Mention, Substandard and Doubtful categories are disaggregated to separate pools. The criticized rating categories utilized by management generally follow bank regulatory definitions. The Special Mention category includes assets that are currently protected but are potentially weak, resulting in an undue and unwarranted credit risk, but not to the point of justifying a Substandard classification. Loans in the Substandard category have well-defined weaknesses that jeopardize the liquidation of the debt, and have a distinct possibility that some loss will be sustained if the weaknesses are not corrected. All loans greater than 90 days past due, or for which any portion of the loan represents a specific allocation of the allowance for loan losses are placed in Substandard or Doubtful.

To help ensure that risk ratings are accurate and reflect the present and future capacity of borrowers to repay a loan as agreed, the Company has a structured loan rating process, which dictates that, at a minimum, credit reviews are mandatory for all commercial and commercial mortgage loan relationships with aggregate balances in excess of $1,000,000 within a 12‑month period. Generally, consumer and residential mortgage loans are included in the Pass categories unless a specific action, such as bankruptcy, delinquency, or death occurs to raise awareness of a possible credit event. The Company’s commercial relationship managers are responsible for the timely and accurate risk rating of the loans in their portfolios at origination and on an ongoing basis. Risk ratings are assigned by the account officer, but require independent review and rating concurrence from the Company’s internal Loan Review Department. The Loan Review Department is an experienced, independent function which reports directly to the Board’s Audit Committee. The scope of commercial portfolio coverage by the Loan Review Department is defined and presented to the Audit Committee for approval on an annual basis. The approved scope of coverage for 2019 required review of a minimum range of 50% to 55% of the commercial loan portfolio.

In addition to loan monitoring by the account officer and Loan Review Department, the Company also requires presentation of all credits rated Pass‑6 with aggregate balances greater than $2,000,000, all credits rated Special Mention or Substandard with aggregate balances greater than $250,000, and all credits rated Doubtful with aggregate balances greater than $100,000 on an individual basis to the Company’s Loan Loss Reserve Committee on a quarterly basis. Additionally, the Asset Quality Task Force, which is a group comprised of senior level personnel, meets monthly to monitor the status of problem loans.

The following table presents the classes of the commercial and commercial real estate loan portfolios summarized by the aggregate Pass and the criticized categories of Special Mention, Substandard and Doubtful within the internal risk rating system.


	AT DECEMBER 31, 2019
			SPECIAL
	PASS		MENTION		SUBSTANDARD		DOUBTFUL		TOTAL
	(IN THOUSANDS)
Commercial and industrial	$	161,147	$	853	$	11,922	$	—	$	173,922
Commercial loans secured by owner occupied real estate		88,942		1,384		1,329		—		91,655
Commercial loans secured by non-owner occupied real estate		362,027		—		1,600		8		363,635
Total	$	612,116	$	2,237	$	14,851	$	8	$	629,212


	AT DECEMBER 31, 2018
			SPECIAL
	PASS		MENTION		SUBSTANDARD		DOUBTFUL		TOTAL
	(IN THOUSANDS)
Commercial and industrial	$	154,510	$	2,089	$	1,680	$	—	$	158,279
Commercial loans secured by owner occupied real estate		86,997		3,769		1,139		—		91,905
Commercial loans secured by non-owner occupied real estate		349,954		6,316		262		11		356,543
Total	$	591,461	$	12,174	$	3,081	$	11	$	606,727

It is generally the policy of the Bank that the outstanding balance of any residential mortgage loan that exceeds 90‑days past due as to principal and/or interest is transferred to non-accrual status and an evaluation is completed to determine the fair value of the collateral less selling costs, unless the balance is minor. A charge down is recorded for any deficiency balance determined from the collateral evaluation. The remaining non-accrual balance is reported as impaired with no specific allowance. It is generally the policy of the Bank that the outstanding balance of any consumer loan that exceeds 90‑days past due as to principal and/or interest is charged off. The following tables present the performing and non-performing outstanding balances of the residential and consumer portfolio classes.


	AT DECEMBER 31, 2019
			NON-
	PERFORMING		PERFORMING		TOTAL
	(IN THOUSANDS)
Real estate – residential mortgage	$	233,760	$	1,479	$	235,239
Consumer		18,255		—		18,255
Total	$	252,015	$	1,479	$	253,494


	AT DECEMBER 31, 2018
			NON-
	PERFORMING		PERFORMING		TOTAL
	(IN THOUSANDS)
Real estate – residential mortgage	$	236,754	$	1,210	$	237,964
Consumer		17,591		—		17,591
Total	$	254,345	$	1,210	$	255,555

Management further monitors the performance and credit quality of the loan portfolio by analyzing the age of the portfolio as determined by the length of time a recorded payment is past due. The following tables present the classes of the loan portfolio summarized by the aging categories of performing loans and nonaccrual loans.


	AT DECEMBER 31, 2019
													90 DAYS
			30 – 59		60 – 89								PAST DUE
			DAYS		DAYS		90 DAYS		TOTAL		TOTAL		AND STILL
	CURRENT		PAST DUE		PAST DUE		PAST DUE		PAST DUE		LOANS		ACCRUING
	(IN THOUSANDS)
Commercial and industrial	$	173,922	$	—	$	—	$	—	$	—	$	173,922	$	—
Commercial loans secured by owner occupied real estate		91,538		117		—		—		117		91,655		—
Commercial loans secured by non-owner occupied real estate		363,635		—		—		—		—		363,635		—
Real estate – residential mortgage		231,022		2,331		864		1,022		4,217		235,239		—
Consumer		18,190		42		23		—		65		18,255		—
Total	$	878,307	$	2,490	$	887	$	1,022	$	4,399	$	882,706	$	—


	AT DECEMBER 31, 2018
													90 DAYS
			30 – 59		60 – 89								PAST DUE
			DAYS		DAYS		90 DAYS		TOTAL		TOTAL		AND STILL
	CURRENT		PAST DUE		PAST DUE		PAST DUE		PAST DUE		LOANS		ACCRUING
	(IN THOUSANDS)
Commercial and industrial	$	158,279	$	—	$	—	$	—	$	—	$	158,279	$	—
Commercial loans secured by owner occupied real estate		91,905		—		—		—		—		91,905		—
Commercial loans secured by non-owner occupied real estate		355,963		580		—		—		580		356,543		—
Real estate – residential mortgage		232,465		3,651		472		1,376		5,499		237,964		—
Consumer		17,408		153		30		—		183		17,591		—
Total	$	856,020	$	4,384	$	502	$	1,376	$	6,262	$	862,282	$	—

An allowance for loan losses (“ALL”) is maintained to support loan growth and cover charge-offs from the loan portfolio. The ALL is based on management’s continuing evaluation of the risk characteristics and credit quality of the loan portfolio, assessment of current economic conditions, diversification and size of the portfolio, adequacy of collateral, past and anticipated loss experience, and the amount of non-performing loans.

Loans that are collectively evaluated for impairment are analyzed with general allowances being made as appropriate. For general allowances, historical loss trends are used in the estimation of losses in the current portfolio. These historical loss amounts are complemented by consideration of other qualitative factors.

Management tracks the historical net charge-off activity at each risk rating grade level for the entire commercial portfolio and at the aggregate level for the consumer, residential mortgage and small business portfolios. A historical charge-off factor is calculated utilizing a rolling 12 consecutive historical quarters for the commercial portfolios. This historical charge-off factor for the consumer, residential mortgage and small business portfolios are based on a three-year historical average of actual loss experience.

The Company uses a comprehensive methodology and procedural discipline to maintain an ALL to absorb inherent losses in the loan portfolio. The Company believes this is a critical accounting policy since it involves significant estimates and judgments. The allowance consists of three elements: (1) an allowance established on specifically identified problem loans, (2) formula driven general reserves established for loan categories based upon historical loss experience and other qualitative factors which include delinquency, non-performing and TDR loans, loan trends, economic trends, concentrations of credit, trends in loan volume, experience and depth of management, examination and audit results, effects of any changes in lending policies, and trends in policy, financial information, and documentation exceptions, and (3) a general risk reserve which provides support for variance from our assessment of the previously listed qualitative factors, provides protection against credit risks resulting from other inherent risk factors contained in the Company’s loan portfolio, and recognizes the model and estimation risk associated with the specific and formula driven allowances. The qualitative factors used in the formula driven general reserves are evaluated quarterly (and revised if necessary) by the Company’s management to establish allocations which accommodate each of the listed risk factors.

“Pass” rated credits are segregated from “Criticized” and “Classified” credits for the application of qualitative factors.

Management reviews the loan portfolio on a quarterly basis using a defined, consistently applied process in order to make appropriate and timely adjustments to the ALL. When information confirms all or part of specific loans to be uncollectible, these amounts are promptly charged off against the ALL.