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Harleysville Group Inc (HGIC) SEC Filing 10-K Annual report for the fiscal year ending Monday, December 31, 2007

Harleysville Group Inc

CIK: 792013 Ticker: HGIC

Exhibit 99.1

Harleysville Group Reports Record Fourth Quarter and Year-End 2007 Results

Fourth quarter and year-end highlights:

  • Record operating earnings increase 17 percent to $0.83 per share in quarter, and by 20 percent to $3.17 for year
  • Statutory combined ratio1 improves by 1.6 points to 96.4 percent in quarter and by 1.9 points to 96.7 percent for year
  • Operating return on equity grows to 13.8 percent
  • Book value up 11 percent to $25.03
  • Operating cash flow in 2007 of $171.5 million

HARLEYSVILLE, Pa.--(BUSINESS WIRE)--Harleysville Group Inc. (NASDAQ:HGIC) today reported record diluted operating income of $0.83 per share for the fourth quarter of 2007, compared to $0.71 per share in the fourth quarter of 2006. For the 12-month periods, the company reported diluted operating income of $3.17 per share in 2007 and $2.65 per share in 2006. In 2007, 12-month operating income includes a benefit of $0.06 per share resulting from the gain on the company’s sale of an office building during the second quarter. Operating income is a non-GAAP financial measure defined by the company as net income excluding after-tax realized gains and losses on investments, and the cumulative effect of an accounting change, net of income tax.

“We’re pleased to report that we finished 2007 the same way it began—with another solid quarter and ongoing steady improvement in our operating performance. As a result, we concluded the year by reporting our 12th consecutive quarter of double-digit percentage growth in operating income,” commented Michael L. Browne, Harleysville Group’s president and chief executive officer. “Our statutory combined ratio for the fourth quarter was 96.4 percent, or 1.6 points better than the same period a year ago. And, we produced an operating return on equity of 13.8 percent, compared to 13.0 percent in 2006. In addition, our operating earnings for the fourth quarter increased 17 percent to match the $0.83 per share record set in the third quarter. We continue to maintain our solid capital base and a strong balance sheet, a modest debt-to-capital ratio of 14 percent2, a high-quality investment portfolio, and a premium-to-surplus ratio of 1.2 to 1—all of which continue to anchor the sound financial foundation necessary for us to write our agents’ best business.

“Our results continue to demonstrate how fundamentally different we are now compared to just a few years ago,” Browne continued. “Today, we have differentiated ourselves from the competition by our consistent and relentless execution of the basics of this business—a proactive capital management strategy; our sophisticated commercial lines underwriting approach, which features predictive modeling; demonstrated success in personal lines; innovative technology that supports ease of doing business for our agents; an extensive regional field structure that puts resources and decision-makers close to the point of sale; high-quality claims service; and ongoing strong relationships with our agency partners—all supported by the ‘Good people to know’ at Harleysville.”


The following information was filed by Harleysville Group Inc (HGIC) on Thursday, February 21, 2008 as an 8K 2.02 statement, which is an earnings press release pertaining to results of operations and financial condition. It may be helpful to assess the quality of management by comparing the information in the press release to the information in the accompanying 10-K Annual Report statement of earnings and operation as management may choose to highlight particular information in the press release.

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

——————

FORM 10-K

——————

ý

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2007

OR

¨

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _________ to _________

———————

HARLEYSVILLE GROUP INC.

(Exact name of registrant as specified in its charter)

Delaware

0-14697

51-0241172

(State or other jurisdiction of

(Commission file number)

(I.R.S. Employer

incorporation or organization)

 

Identification No.)

355 Maple Avenue, Harleysville, PA 19438-2297

(Address of principal executive offices) (Zip Code)

Registrant’s telephone number, including area code: (215) 256-5000

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $1 par value

(Title of class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No ý.

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No ý.

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No ¨.

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K ý.

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

Large accelerated filer ¨    Accelerated filer ý    Non-accelerated filer ¨    Smaller reporting company ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act) Yes ¨ No ý.

On June 30, 2007, the last business day of the registrant’s most recently completed second fiscal quarter, the aggregate market value (based on the closing sales price on that date) of the voting stock held by non-affiliates of the registrant was $487,491,848.

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date:  30,386,679 shares of Common Stock outstanding on March 3, 2008

DOCUMENTS INCORPORATED BY REFERENCE:

1.

Portions of the registrant’s proxy statement relating to the annual meeting of stockholders to be held April 23, 2008 are incorporated by reference in Part III of this report.

 

 




HARLEYSVILLE GROUP INC.

ANNUAL REPORT ON FORM 10-K

DECEMBER 31, 2007


 

 

PART I

 

Page

ITEM 1.

 

BUSINESS

 

1

ITEM 1A.

 

RISK FACTORS

 

15

ITEM 1B.

 

UNRESOLVED STAFF COMMENTS

 

15

ITEM 2.

 

PROPERTIES

 

16

ITEM 3.

 

LEGAL PROCEEDINGS

 

16

ITEM 4.

 

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

16

 

 

PART II

 

 

ITEM 5.

 

MARKET FOR REGISTRANT’S COMMON STOCK, RELATED

STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY

SECURITIES

 

17

ITEM 6.

 

SELECTED FINANCIAL DATA

 

19

ITEM 7.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

 

20

ITEM 7A.

 

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT

MARKET RISK

 

45

ITEM 8.

 

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

46

ITEM 9.

 

CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS

ON ACCOUNTING AND FINANCIAL DISCLOSURE

 

76

ITEM 9A.

 

CONTROLS AND PROCEDURES

 

76

ITEM 9B.

 

OTHER INFORMATION

 

76

 

 

PART III

 

 

ITEM 10.

 

DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

 

78

ITEM 11.

 

EXECUTIVE COMPENSATION

 

78

ITEM 12.

 

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT AND RELATED STOCKHOLDERS MATTERS

 

78

ITEM 13.

 

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND

DIRECTOR INDEPENDENCE

 

78

ITEM 14.

 

PRINCIPAL ACCOUNTING FEES AND SERVICES

 

78

 

 

PART IV

 

 

ITEM 15.

 

EXHIBITS, FINANCIAL STATEMENT SCHEDULES

 

79





PART I

Item 1.

Business.

General

Harleysville Group Inc. (the Company) is an insurance holding company headquartered in Pennsylvania which, through its subsidiaries, engages in the property and casualty insurance business on a regional basis. As used herein, “Harleysville Group” refers to Harleysville Group Inc. and its subsidiaries.

The Company is a Delaware corporation formed by Harleysville Mutual Insurance Company (the Mutual Company) in 1979 as a wholly owned subsidiary. In May 1986, the Company completed an initial public offering of its common stock, reducing the percentage of outstanding shares owned by the Mutual Company to approximately 70%. In April 1992, the Mutual Company completed a secondary public offering of a portion of the Company’s common stock then owned by it, further reducing the percentage of outstanding shares owned by the Mutual Company. At December 31, 2007, the Mutual Company owned approximately 53% of the Company’s outstanding shares.

Harleysville Group and the Mutual Company operate together to pursue a strategy of underwriting a broad array of personal and commercial coverages. These insurance coverages are marketed primarily in the eastern and midwestern United States through approximately 1,500 insurance agencies. Regional offices are maintained in Georgia, Illinois, Indiana, Maryland, Massachusetts, Michigan, Minnesota, New Jersey, New York, North Carolina, Pennsylvania, Tennessee, and Virginia. The Company’s property and casualty insurance subsidiaries are: Harleysville-Atlantic Insurance Company (Atlantic), Harleysville Insurance Company (HIC), Harleysville Insurance Company of New Jersey (HNJ), Harleysville Insurance Company of New York (HIC New York), Harleysville Insurance Company of Ohio (HIC Ohio), Harleysville Lake States Insurance Company (Lake States), Harleysville Preferred Insurance Company (Preferred), and Harleysville Worcester Insurance Company (Worcester). Mid-America Insurance Company (Mid-America), a former subsidiary, was merged into Worcester in 2007.

The Company operates regionally. Management believes that the Company’s regional organization permits each regional operation to benefit from economies of scale provided by centralized support while encouraging local marketing autonomy and managerial entrepreneurship. Services which directly involve the insured or the agent (i.e., underwriting, claims and marketing) generally are performed regionally in accordance with Company-wide standards to promote high quality service, while actuarial, investment, legal, data processing and similar services are performed centrally. The Company’s network of regional insurance companies has expanded significantly in the last twenty-four years. In 1983, the Company acquired Worcester, a property and casualty insurer which has conducted business in New England since 1823. In 1984, HNJ was formed by the Company and began underwriting property and casualty insurance in New Jersey. In 1987, the Company acquired Atlantic, a property and casualty insurer which has conducted business in the southeastern United States since 1905. In 1991, the Company acquired Mid-America, which conducted business in Connecticut, and HIC New York, which primarily conducts business in upstate New York. In 1993, the Company acquired Lake States, which primarily conducts business in Michigan. In 1994, the Company formed HIC Ohio which began underwriting property and casualty insurance in Ohio. In 1997, the Company acquired HIC, which primarily conducts business in Minnesota and neighboring states.

The Company’s property and casualty subsidiaries participate in an intercompany pooling arrangement whereby these subsidiaries cede to the Mutual Company all of their net premiums written and assume from the Mutual Company a portion of the pooled business, which includes substantially all of the Mutual Company’s property and casualty insurance business. See “Business - Pooling Arrangement.”

Business Segments

Harleysville Group has three segments which consist of the personal lines of insurance, the commercial lines of insurance and the investment function. Financial information about these segments is set forth in Note 12 of the Notes to Consolidated Financial Statements.




Narrative Description of Business

Property and Casualty Underwriting

Harleysville Group and the Mutual Company together underwrite a broad line of personal and commercial property and casualty coverages, including automobile, homeowners, commercial multi-peril and workers compensation. The Mutual Company and the Company’s insurance subsidiaries participate in an intercompany pooling arrangement under which such subsidiaries and the Mutual Company combine their property and casualty business.

Harleysville Group and the Mutual Company have a pooled rating of “A-” (excellent) which was affirmed by A.M. Best Company, Inc. (Best’s) in January 2008. Best’s ratings are based upon factors relevant to policyholders and are not directed toward the protection of investors. Management believes that the Best’s rating is an important factor in marketing Harleysville Group’s products to its agents and customers, and that the current rating is satisfactory in that regard.

The following table sets forth ratios for the Company’s property and casualty subsidiaries, prepared in accordance with U.S. generally accepted accounting principles (GAAP) and with statutory accounting practices (SAP) prescribed or permitted by state insurance authorities. The statutory combined ratio is a standard measure of underwriting profitability. This ratio is the sum of (i) the ratio of incurred losses and loss settlement expenses to net earned premium (loss ratio); (ii) the ratio of expenses incurred for commissions, premium taxes, administrative and other underwriting expenses to net written premium (expense ratio); and (iii) the ratio of dividends to policyholders to net earned premium (dividend ratio). The GAAP combined ratio is calculated in the same manner except that it is based on GAAP amounts and the denominator for each component is net earned premium. When the combined ratio is under 100%, underwriting results are generally considered profitable. Conversely, when the combined ratio is over 100%, underwriting results are generally considered unprofitable. The combined ratio does not reflect investment income, federal income taxes or other non-operating income or expense. Harleysville Group’s operating income is a function of both underwriting results and investment income.

HARLEYSVILLE GROUP BUSINESS ONLY

 

 

Year Ended December 31,

 

 

 

2007

 

2006

 

2005

 

GAAP combined ratio

 

 

96.9

%

 

99.1

%

 

101.9

%

Statutory operating ratios:

 

 

 

 

 

 

 

 

 

 

Loss ratio

 

 

62.8

%

 

64.3

%

 

67.4

%

Expense and dividend ratios

 

 

33.9

%

 

34.3

%

 

34.8

%

Statutory combined ratio

 

 

96.7

%

 

98.6

%

 

102.2

%




2



The following table sets forth the net written premiums and combined ratios by line of insurance, prepared in accordance with statutory accounting practices prescribed or permitted by state insurance authorities, for Harleysville Group for the periods indicated:

HARLEYSVILLE GROUP BUSINESS ONLY

 

 

Year Ended December 31,

 

 

 

2007

 

2006

 

2005

 

 

 

(dollars in thousands)

 

Net Premiums Written

 

 

 

 

 

 

 

 

 

 

Commercial:

 

 

 

 

 

 

 

 

 

 

Automobile

 

$

193,228

 

$

206,316

 

$

221,680

 

Workers compensation

 

 

97,017

 

 

97,113

 

 

95,877

 

Commercial multi-peril

 

 

325,911

 

 

321,270

 

 

306,267

 

Other commercial

 

 

77,012

 

 

71,189

 

 

68,532

 

Total commercial

 

 

693,168

 

 

695,888

 

 

692,356

 

Personal:

 

 

 

 

 

 

 

 

 

 

Automobile

 

 

69,052

 

 

71,270

 

 

78,787

 

Homeowners

 

 

66,946

 

 

63,124

 

 

59,175

 

Other personal

 

 

8,827

 

 

8,535

 

 

8,726

 

Total personal

 

 

144,825

 

 

142,929

 

 

146,688

 

Total Harleysville Group Business

 

$

837,993

 

$

838,817

 

$

839,044

 

Combined Ratios

 

 

 

 

 

 

 

 

 

 

Commercial:

 

 

 

 

 

 

 

 

 

 

Automobile

 

 

94.7

%

 

99.3

%

 

101.1

%

Workers compensation

 

 

112.2

%

 

117.2

%

 

124.0

%

Commercial multi-peril

 

 

97.8

%

 

98.9

%

 

101.5

%

Other commercial

 

 

83.8

%

 

86.6

%

 

98.7

%

Total commercial

 

 

97.5

%

 

100.3

%

 

104.3

%

Personal:

 

 

 

 

 

 

 

 

 

 

Automobile

 

 

99.7

%

 

99.3

%

 

99.2

%

Homeowners

 

 

86.8

%

 

82.6

%

 

87.6

%

Other personal

 

 

79.8

%

 

69.8

%

 

72.3

%

Total personal

 

 

92.7

%

 

90.6

%

 

93.1

%

Total Harleysville Group Business

 

 

96.7

%

 

98.6

%

 

102.2

%

Pooling Arrangement

The Company’s property and casualty subsidiaries participate in an intercompany pooling arrangement with the Mutual Company. The underwriting pool is intended to produce a more uniform and stable underwriting result from year to year for all companies in the pool than they would experience individually and to reduce the risk of loss of any of the pool participants by spreading the risk among all the participants. Each company participating in the pool has at its disposal the capacity of the entire pool, rather than being limited to policy exposures of a size commensurate with its own capital and surplus. The additional capacity exists because such policy exposures are spread among all the pool participants which each have their own capital and surplus. Regulation is applied to the individual companies rather than to the pool.

Pursuant to the terms of the pooling agreement with the Mutual Company, each of the Company’s subsidiary participants cedes premiums, losses and underwriting expenses on all of its business to the Mutual Company which, in turn, retrocedes to such subsidiaries a specified portion of premiums, losses and underwriting expenses of the Mutual Company and such subsidiaries. Under the terms of the intercompany pooling agreement which became effective January 1, 1986, Preferred and HNJ ceded to the Mutual Company all of their insurance business written on or after January 1, 1986. All of the Mutual Company’s property and casualty insurance business written or in force on or after January 1, 1986, was also included in the pooled business. The pooling agreement provides, however, that Harleysville Group is not liable for any losses incurred by the Mutual Company, Preferred and HNJ prior to January 1, 1986. The



3



pooling agreement does not legally discharge Harleysville Group from its primary liability for the full amount of the policies ceded. However, it makes the Mutual Company liable to Harleysville Group to the extent of the business ceded.

The following table sets forth a chronology of the changes that have occurred in the pooling agreement since it became effective on January 1, 1986.

Chronology of Changes in Pooling Agreement

Date

 

Harleysville

Group

Percentage

 

Mutual

Company/Pennland

Percentage

 

Event

January 1, 1986

 

30%

 

70%

 

Current pooling agreement began with Preferred and HNJ as participants with the Mutual Company.

July 1, 1987

 

35%

 

65%

 

Atlantic acquired and included in the pool.

January 1, 1989

 

50%

 

50%

 

Worcester included in the pool.

January 1, 1991

 

60%

 

40%

 

HIC New York and Mid-America acquired and included in the pool and the Mutual Company formed Pennland (not a pool participant) to write Pennsylvania personal automobile business.

January 1, 1996

 

65%

 

35%

 

Pennland included in the pool.

January 1, 1997

 

70%

 

30%

 

Lake States included in the pool.

January 1, 1998

 

72%

 

28%

 

HIC included in the pool.

January 1, 2008

 

80%

 

20%

 

Amendment to the pooling agreement.

When pool participation percentages increased as described above, cash and investments equal to the net increase in liabilities assumed less a ceding commission related to the net increase in the liability for unearned premiums, was transferred from the Mutual Company to Harleysville Group.

All premiums, losses, loss settlement expenses and other underwriting expenses are prorated among the parties to the pooling arrangement on the basis of their participation in the pool. The method of establishing reserves is set forth under “Business - Reserves.” The pooling agreement may be amended or terminated by agreement of the parties. Termination may occur only at the end of a calendar year. The Boards of Directors of the Company and the Mutual Company maintain a coordinating committee which reviews and evaluates, and when changes are warranted, approves the pooling arrangements between the Company and the Mutual Company. See “Business-Relationship with the Mutual Company.” In evaluating pool participation changes, the coordinating committee considers current and proposed acquisitions, the relative capital positions and revenue contributions of the pool participants, and growth prospects and ability to access capital markets to support that growth. Harleysville Group does not intend to terminate its participation in the pooling agreement.



4



The following table sets forth the net premiums written and combined ratios by line of insurance for the total pooled business after elimination of management fees, prepared in accordance with statutory accounting practices prescribed or permitted by state insurance authorities, for the periods indicated.

TOTAL POOLED BUSINESS

 

 

Year Ended December 31,

 

 

 

2007

 

2006

 

2005

 

 

 

(dollars in thousands)

 

Net Premiums Written

 

 

 

 

 

 

 

 

 

 

Commercial:

 

 

 

 

 

 

 

 

 

 

Automobile

 

$

268,372

 

$

286,550

 

$

308,576

 

Workers compensation

 

 

134,746

 

 

134,878

 

 

133,161

 

Commercial multi-peril

 

 

452,655

 

 

446,209

 

 

432,788

 

Other commercial

 

 

106,961

 

 

98,874

 

 

96,782

 

Total commercial

 

 

962,734

 

 

966,511

 

 

971,307

 

Personal:

 

 

 

 

 

 

 

 

 

 

Automobile

 

 

95,905

 

 

98,986

 

 

109,840

 

Homeowners

 

 

92,981

 

 

87,672

 

 

84,310

 

Other personal

 

 

12,260

 

 

11,854

 

 

12,119

 

Total personal

 

 

201,146

 

 

198,512

 

 

206,269

 

Total pooled business

 

$

1,163,880

 

$

1,165,023

 

$

1,177,576

 

Combined Ratios(1)

 

 

 

 

 

 

 

 

 

 

Commercial:

 

 

 

 

 

 

 

 

 

 

Automobile

 

 

94.9

%

 

99.5

%

 

101.0

%

Workers compensation

 

 

112.2

%

 

119.0

%

 

124.4

%

Commercial multi-peril

 

 

97.9

%

 

99.8

%

 

99.9

%

Other commercial

 

 

84.8

%

 

78.8

%

 

97.5

%

Total commercial

 

 

97.7

%

 

100.2

%

 

103.5

%

Personal:

 

 

 

 

 

 

 

 

 

 

Automobile

 

 

102.0

%

 

106.9

%

 

100.9

%

Homeowners

 

 

86.9

%

 

82.8

%

 

85.3

%

Other personal

 

 

79.8

%

 

69.8

%

 

72.3

%

Total personal

 

 

93.9

%

 

94.5

%

 

93.1

%

Total pooled business

 

 

97.0

%

 

99.3

%

 

101.6

%

———————

(1)

See the definition of combined ratio in “Business-Property and Casualty Underwriting.”

The combined ratio for the total pooled business differs from Harleysville Group’s combined ratio primarily because of the effect of the inclusion of incurred losses occurring prior to 1986 retained by the Mutual Company and, for 2005, the effect of the aggregate catastrophe reinsurance agreement with the Mutual Company. See Note 2(a) of the Notes to Consolidated Financial Statements and Business–Reinsurance.

Reserves. Loss reserves are estimates at a given point in time of what the insurer expects to pay to claimants for claims occurring on or before such point in time, including claims which have been incurred but not yet reported to the insurer. These are estimates, and it can be expected that the ultimate liability will exceed or be less than such estimates. During the loss settlement period, additional facts regarding individual claims may become known, and consequently it often becomes necessary to refine and adjust the estimates of liability.

Harleysville Group maintains reserves for estimates of the ultimate unpaid cost of all losses incurred, including losses for claims which have been incurred but have not yet been reported to Harleysville Group. Loss settlement expense reserves are intended to cover the ultimate costs of settling all claims, including investigation and litigation costs relating to such claims. The amount of loss reserves for reported claims is based primarily upon a case-by-case evaluation of the type of risk involved and knowledge of the circumstances surrounding each claim and the insurance policy provisions relating to the type of loss. The amounts of loss reserves for incurred but unreported claims and loss settlement expense reserves are determined utilizing historical information by line of insurance as adjusted to



5



current conditions. Inflation is implicitly provided for in the reserving function through analysis of costs, trends and reviews of historical reserving results. Estimates of the liabilities are reviewed and updated on a regular basis using the most recent information on reported claims and a variety of actuarial techniques. With the exception of reserves relating to some workers compensation long-term disability cases, loss reserves are not discounted.

The following table sets forth a reconciliation of beginning and ending net reserves for unpaid losses and loss settlement expenses for the years indicated for the total pooled business on a statutory basis.

TOTAL POOLED BUSINESS

 

 

Year Ended December 31,

 

 

 

2007

 

2006

 

2005

 

 

 

(in thousands)

 

Reserves for losses and
loss settlement expenses,
beginning of the year

 

$

1,893,753

 

$

1,761,198

 


$

1,613,374

 

Incurred losses and loss
settlement expenses:

 

 

 

 

 

 

 

 

 

 

Provision for insured events
of the current year

 

 

756,641

 

 

773,770

 

 

811,778

 

Decrease in provisions for insured
events of prior years

 

 

(26,315

)

 

(17,424

)

 

(19,545

)

Total incurred losses and
loss settlement expenses

 

 

730,326

 

 

756,346

 

 

792,233

 

Payments:

 

 

 

 

 

 

 

 

 

 

Losses and loss settlement expenses
attributable to insured events
of the current year

 

 

251,544

 

 

228,632

 

 

254,441

 

Losses and loss settlement expenses
attributable to insured events
of prior years

 

 

405,441

 

 

395,159

 

 

389,968

 

Total payments

 

 

656,985

 

 

623,791

 

 

644,409

 

Reserves for losses and loss
settlement expenses, end of the year

 

$

1,967,094

 

$

1,893,753

 

$

1,761,198

 

The following table sets forth the development of net reserves for unpaid losses and loss settlement expenses from 1997 through 2007 for the pooled business of the Mutual Company and Harleysville Group on a statutory basis. “Reserve for losses and loss settlement expenses” sets forth the estimated liability for unpaid losses and loss settlement expenses recorded at the balance sheet date for each of the indicated years. This liability represents the estimated amount of losses and loss settlement expenses for claims arising in the current and all prior years that are unpaid at the balance sheet date, including losses incurred but not reported.

The “Reserves reestimated” portion of the table shows the reestimated amount of the previously recorded liability based on experience of each succeeding year. The estimate is increased or decreased as payments are made and more information becomes known about the severity of remaining unpaid claims. For example, the 1997 liability has developed a redundancy after ten years, in that reestimated losses and loss settlement expenses are expected to be lower than the initial estimated liability established in 1997 of $1,125 million by $18.5 million, or 1.6%.

The “Cumulative amount of reserves paid” portion of the table shows the cumulative losses and loss settlement expense payments made in succeeding years for losses incurred prior to the balance sheet date. For example, the 1997 column indicates that as of December 31, 2007, payments of $940.4 million of the currently reestimated ultimate liability for losses and loss settlement expenses had been made.



6



The “Redundancy (deficiency)” portion of the table shows the cumulative redundancy or deficiency at December 31, 2007 of the reserve estimate shown on the top line of the corresponding column. A redundancy in reserves means that reserves established in prior years exceeded actual losses and loss settlement expenses or were reevaluated at less than the original reserved amount. A deficiency in reserves means that the reserves established in prior years were less than actual losses and loss settlement expenses or were reevaluated at more than the originally reserved amounts.

The following table includes all 2007 pool participants as if they had participated in the pooling arrangement in all years indicated except for acquired pool participant companies, which are included from their date of acquisition. Under the terms of the pooling arrangement, Harleysville Group is not responsible for losses on the pooled business of the Mutual Company, Preferred and HNJ occurring prior to January 1, 1986.

TOTAL POOLED BUSINESS

 

 

Year ended December 31,

 

 

1997

 

1998

 

1999

 

2000

 

2001

 

2002

 

2003

 

2004

 

2005

 

2006

 

2007

 

 

(dollars in thousands)

Reserve for losses
and loss settlement
expenses

 

$


1,124,910

 

$


1,172,664

 

$


1,181,066

 

$


1,136,848

 

$


1,147,517

 

$


1,224,380

 

$


1,514,548

 

$


1,613,374

 

$

1,761,198

 

$

1,893,753

 

$

1,967,094

Reserves reestimated:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

One year later

 

 

1,068,687

 

 

1,090,640

 

 

1,115,747

 

 

1,114,404

 

 

1,143,701

 

 

1,397,821

 

 

1,538,929

 

 

1,593,829

 

 

1,743,774

 

 

1,867,438

 

 

 

Two years later

 

 

1,005,208

 

 

1,042,183

 

 

1,097,544

 

 

1,124,881

 

 

1,308,498

 

 

1,459,056

 

 

1,566,305

 

 

1,602,547

 

 

1,746,441

 

 

 

 

 

 

Three years later

 

 

972,318

 

 

1,027,968

 

 

1,106,107

 

 

1,245,333

 

 

1,369,239

 

 

1,501,724

 

 

1,605,840

 

 

1,622,733

 

 

 

 

 

 

 

 

 

Four years later

 

 

961,721

 

 

1,028,927

 

 

1,182,626

 

 

1,290,895

 

 

1,413,644

 

 

1,557,058

 

 

1,630,971

 

 

 

 

 

 

 

 

 

 

 

 

Five years later

 

 

962,861

 

 

1,073,694

 

 

1,214,740

 

 

1,325,808

 

 

1,478,729

 

 

1,585,986

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Six years later

 

 

995,904

 

 

1,099,420

 

 

1,244,763

 

 

1,387,325

 

 

1,505,789

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Seven years later

 

 

1,018,216

 

 

1,126,334

 

 

1,302,257

 

 

1,411,603

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Eight years later

 

 

1,039,515

 

 

1,179,344

 

 

1,324,960

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Nine years later

 

 

1,088,898

 

 

1,197,875

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Ten years later

 

 

1,106,412

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cumulative amount
of reserves paid:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

One year later

 

 

338,377

 

 

358,526

 

 

391,524

 

 

395,561

 

 

372,642

 

 

437,855

 

 

490,353

 

 

389,968

 

 

395,159

 

 

405,441

 

 

 

Two years later

 

 

540,522

 

 

562,908

 

 

609,016

 

 

609,777

 

 

654,045

 

 

759,313

 

 

742,476

 

 

642,066

 

 

673,385

 

 

 

 

 

 

Three years later

 

 

674,740

 

 

695,315

 

 

753,893

 

 

801,234

 

 

884,746

 

 

935,691

 

 

921,520

 

 

835,193

 

 

 

 

 

 

 

 

 

Four years later

 

 

756,502

 

 

777,204

 

 

864,840

 

 

945,886

 

 

1,005,199

 

 

1,051,788

 

 

1,042,755

 

 

 

 

 

 

 

 

 

 

 

 

Five years later

 

 

801,602

 

 

838,597

 

 

951,286

 

 

1,019,943

 

 

1,076,672

 

 

1,127,999

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Six years later

 

 

837,855

 

 

892,222

 

 

1,001,074

 

 

1,066,271

 

 

1,130,754

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Seven years later

 

 

877,219

 

 

926,315

 

 

1,035,686

 

 

1,102,146

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Eight years later

 

 

902,405

 

 

952,929

 

 

1,062,051

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Nine years later

 

 

924,160

 

 

972,123

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Ten years later

 

 

940,392

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cumulative redundancy/
(deficiency)

 

 

18,498

 

 

(25,211

)

 

(143,894

)

 

(274,755

)

 

(358,272

)

 

(361,606

)

 

(116,423

)

 

(9,359

)

 

14,757

 

 

26,315

 

 

 

Cumulative redundancy/
(deficiency) expressed
as a percent of
year-end reserves

 

 

1.6%

 

 

(2.1%

)

 

(12.2%

)

 

(24.2%

)

 

(31.2%

)

 

(29.5%

)

 

(7.7%

)

 

(0.6%

)

 

0.8%

 

 

1.4%

 

 

 

Cumulative redundancy/
(deficiency) excluding pre-1986 reserve development (1)

 

 

59,500

 

 

13,304

 

 

(106,911

)

 

(240,159

)

 

(324,503

)

 

(330,018

)

 

(92,505

)

 

7,439

 

 

26,502

 

 

30,621

 

 

 

———————

(1)

Excludes business not included in pooling arrangement with Harleysville Group.

Harleysville Group’s reserves primarily are derived from those established for the total pooled business. The terms of the pooling agreement provide that Harleysville Group is not liable for any losses incurred by the Mutual Company, Preferred and HNJ prior to January 1, 1986. The GAAP loss reserve experience of Harleysville Group, as reflected in its financial statements, is shown in the following table which sets forth a reconciliation of beginning and ending net reserves for unpaid losses and loss settlement expenses for the years indicated for the business of Harleysville Group only.



7



HARLEYSVILLE GROUP BUSINESS ONLY

 

 

Year Ended December 31,

 

 

 

2007

 

2006

 

2005

 

 

 

(in thousands)

 

Reserves for losses and
loss settlement expenses,
beginning of the year

 

$

1,329,849

 

$

1,237,090

 

$

1,131,609

 

Incurred losses and loss
settlement expenses:

 

 

 

 

 

 

 

 

 

 

Provision for insured
events of the current year

 

 

545,077

 

 

557,908

 

 

584,929

 

Decrease in provision for
insured events of prior years

 

 

(22,047

)

 

(18,085

)

 

(17,533

)

Total incurred losses and
loss settlement expenses

 

 

523,030

 

 

539,823

 

 

567,396

 

Payments:

 

 

 

 

 

 

 

 

 

 

Losses and loss settlement
expenses attributable to
insured events of the
current year

 

 

181,406

 

 

165,409

 

 

183,645

 

Losses and loss settlement
expenses attributable to
insured events of prior years

 

 

289,661

 

 

281,655

 

 

278,270

 

Total payments

 

 

471,067

 

 

447,064

 

 

461,915

 

Reserves for losses and loss
settlement expenses, end of the year

 

$

1,381,812

 

$

1,329,849

 

$

1,237,090

 

See page 9 for reconciliation of net reserves to gross reserves.

Harleysville Group recognized net favorable development in the provision for insured events of prior years of $22.0 million in 2007, primarily due to lower-than-expected claims severity broadly experienced across all casualty lines in accident years 2003 through 2006, partially offset by adverse development in the 2002 and prior accident years. The favorable development consisted of $12.5 million in commercial lines and $9.5 million in personal lines.

Harleysville Group recognized net favorable development in the provision for insured events of prior years of $18.1 million in 2006, primarily due to lower-than-expected claims severity in accident years 2002 through 2005 for most commercial and personal lines of business, partially offset by greater-than-expected claims severity in the 2001 and prior accident years. The favorable development consisted of $8.1 million in commercial lines and $10.0 million in personal lines.

Harleysville Group recognized net favorable development in the provision for insured events of prior years of $17.5 million in 2005, primarily due to lower-than-expected claims severity in accident years 2004 and 2003, partially offset by greater-than-expected claims severity in commercial lines in 2002 and prior accident years. The favorable development consisted of $3.9 million in commercial lines and $13.6 million in personal lines.

The following table sets forth the development of net reserves for unpaid losses and loss settlement expenses for Harleysville Group. The effect of changes to the pooling agreement participation is reflected in this table. For example, the January 1, 1998 increase in Harleysville Group’s pooling participation from 70% to 72% is reflected in the first line of the 1998 column. Amounts of assets equal to increases in net liabilities were transferred to Harleysville Group from the Mutual Company in conjunction with each respective pooling change. The amount of the assets transferred has been netted against and has reduced the cumulative amounts paid for years prior to the pooling changes.



8



For example, the 1997 column of the “Cumulative amount of reserves paid” portion of the table reflects the assets transferred in conjunction with the 1998 increase in the pooling percentage from 70% to 72% as a decrease netted in the “one year later” line. The cumulative amounts paid are reflected in this manner to maintain comparability. This is because when Harleysville Group pays claims subsequent to the date of a pool participation increase, the amounts paid are greater however, the prior year’s reserve amounts are reflective of a lower pool participation percentage. By reflecting pooling participation increases in this manner, loss development is not obscured. Loss development reflects Harleysville Group’s share of the total pooled business loss development since January 1, 1986 when Harleysville Group began participation, plus loss development of any subsidiary not participating in the pooling agreement.

Loss development information for the total pooled business is presented on pages 6 to 8 to provide greater analysis of underlying claims development.

HARLEYSVILLE GROUP BUSINESS

 

 

Year Ended December 31,

 

 

1997

 

1998

 

1999

 

2000

 

2001

 

2002

 

2003

 

2004

 

2005

 

2006

 

2007

 

 

(dollars in thousands)

Reserve for losses and loss settlement expenses

 

$

793,563

 

$

813,519

 

$

823,914

 

$

792,584

 

$

800,861

 

$

857,182

 

$

1,062,660

 

$

1,131,609

 

$

1,237,090

 

$

1,329,849

 

$

1,381,812

Reserves reestimated:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

One year later

 

 

750,956

 

 

753,987

 

 

774,977

 

 

775,234

 

 

796,213

 

 

976,241

 

 

1,075,122

 

 

1,114,076

 

 

1,219,005

 

 

1,307,802

 

 

 

Two years later

 

 

704,157

 

 

717,324

 

 

761,234

 

 

781,117

 

 

909,048

 

 

1,015,209

 

 

1,091,322

 

 

1,114,813

 

 

1,217,825

 

 

 

 

 

 

Three years later

 

 

678,757

 

 

706,491

 

 

765,816

 

 

862,320

 

 

947,660

 

 

1,042,276

 

 

1,114,275

 

 

1,126,248

 

 

 

 

 

 

 

 

 

Four years later

 

 

670,534

 

 

705,615

 

 

815,380

 

 

889,996

 

 

975,978

 

 

1,076,597

 

 

1,129,270

 

 

 

 

 

 

 

 

 

 

 

 

Five years later

 

 

669,789

 

 

732,315

 

 

833,373

 

 

911,482

 

 

1,017,319

 

 

1,094,325

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Six years later

 

 

688,055

 

 

745,714

 

 

851,335

 

 

950,295

 

 

1,033,702

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Seven years later

 

 

698,996

 

 

761,438

 

 

887,252

 

 

964,675

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Eight years later

 

 

710,694

 

 

794,126

 

 

900,498

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Nine years later

 

 

740,893

 

 

804,369

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Ten years later

 

 

750,403

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cumulative amount of reserves paid:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

One year later

 

 

228,622

 

 

252,972

 

 

279,153

 

 

282,110

 

 

265,422

 

 

312,224

 

 

350,082

 

 

278,270

 

 

281,655

 

 

289,661

 

 

 

Two years later

 

 

371,624

 

 

397,685

 

 

433,901

 

 

434,579

 

 

465,001

 

 

541,063

 

 

529,126

 

 

456,921

 

 

479,720

 

 

 

 

 

 

Three years later

 

 

465,897

 

 

491,274

 

 

536,547

 

 

569,696

 

 

628,494

 

 

665,513

 

 

655,219

 

 

593,715

 

 

 

 

 

 

 

 

 

Four years later

 

 

523,050

 

 

548,696

 

 

613,701

 

 

671,230

 

 

712,677

 

 

746,455

 

 

740,251

 

 

 

 

 

 

 

 

 

 

 

 

Five years later

 

 

553,984

 

 

590,172

 

 

673,327

 

 

722,038

 

 

761,490

 

 

799,069

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Six years later

 

 

577,360

 

 

626,171

 

 

706,659

 

 

752,787

 

 

798,172

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Seven years later

 

 

603,092

 

 

648,203

 

 

728,973

 

 

776,360

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Eight years later

 

 

618,715

 

 

664,758

 

 

745,698

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Nine years later

 

 

631,916

 

 

676,320

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Ten years later

 

 

641,345

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net cumulative

redundancy/

(deficiency)

 

 

43,160

 

 

9,150

 

 

(76,584

)

 

(172,091

)

 

(232,841

)

 

(237,143

)

 

(66,610

)

 

5,361

 

 

19,265

 

 

22,047

 

 

 

Net cumulative

redundancy/

(deficiency)

expressed as a

percent of year

end reserves

 

 

5.4%

 

 

1.1%

 

 

(9.3%)

 

 


(21.7%

)

 

(29.1%


)

 

(27.7%

)

 


(6.3%

)

 

0.5%

 

 

1.6%

 

 

1.7%

 

 

 

Gross reserve

 

$

868,393

 

$

893,420

 

$

901,352

 

$

864,843

 

$

879,056

 

$

928,335

 

$

1,219,977

 

$

1,317,735

 

$

1,480,802

 

$

1,493,645

 

$

1,546,690

Ceded reserve

 

 

74,830

 

 

79,901

 

 

77,438

 

 

72,259

 

 

78,195

 

 

71,153

 

 

157,317

 

 

186,126

 

 

243,712

 

 

163,796

 

 

164,878

Net reserve

 

$

793,563

 

$

813,519

 

$

823,914

 

$

792,584

 

$

800,861

 

$

857,182

 

$

1,062,660

 

$

1,131,609

 

$

1,237,090

 

$

1,329,849

 

$

1,381,812

Gross cumulative

redundancy/

(deficiency)

 

$

(42,495

)

$

(74,063

)

$

(181,572

)

$

(301,368

)

$

(359,590

)

$

(368,899

)

$

(127,160

)

$

(18,739

)

$

(6,189

)

$

8,956

 

 

 

Gross re-estimated

 

$

910,888

 

$

967,483

 

$

1,082,924

 

$

1,166,211

 

$

1,238,646

 

$

1,297,234

 

$

1,347,137

 

$

1,336,474

 

$

1,486,991

 

$

1,484,689

 

 

 

Ceded re-estimated

 

 

160,485

 

 

163,114

 

 

182,426

 

 

201,536

 

 

204,944

 

 

202,909

 

 

217,867

 

 

210,226

 

 

269,166

 

 

176,887

 

 

 

Net re-estimated

 

$

750,403

 

$

804,369

 

$

900,498

 

$

964,675

 

$

1,033,702

 

$

1,094,325

 

$

1,129,270

 

$

1,126,248

 

$

1,217,825

 

$

1,307,802

 

 

 

———————

Note:

The amount of cash and investments received equal to the increase in liabilities for unpaid losses and loss settlement expenses was $28,318,000 and $12,392,000 for the changes in pool participation in 1997 and 1998, respectively.



9



Reinsurance. Harleysville Group follows the customary industry practice of reinsuring a portion of its exposures and paying to the reinsurers a portion of the premiums received. Insurance is ceded principally to reduce the net liability on individual risks and to protect against catastrophic losses. Reinsurance does not legally discharge an insurer from its primary liability for the full amount of the policies, although it does make the assuming reinsurer liable to the insurer to the extent of the reinsurance ceded. Therefore, a ceding company is subject to credit risk with respect to its reinsurers. Harleysville Group has not entered into any finite reinsurance agreements.

The reinsurance described below is maintained for the Company’s subsidiaries and the Mutual Company and its wholly owned subsidiaries. Reinsurance premiums and recoveries are allocated to participants in the pooling agreement according to pooling percentages.

Reinsurance for property and auto physical damage losses is currently maintained under a per risk excess of loss treaty affording recovery to $13.0 million above a retention of $2.0 million. Harleysville Group’s 2007 pooling share of such recovery would be $9.4 million above a retention of $1.4 million. In addition, the Company’s subsidiaries and the Mutual Company and its wholly owned subsidiaries are reinsured under a catastrophe reinsurance treaty effective for one year from July 1, 2007 which provides coverage ranging from 75% to 85% of up to $250.0 million in excess of a retention of $50.0 million for any given catastrophe. Harleysville Group’s 2007 pooling share of this coverage would range from 75% to 85% of up to $180.0 million in excess of a retention of $36.0 million for any given catastrophe. Accordingly, pursuant to the terms of the treaty, the maximum recovery would be $195.0 million for any catastrophe involving an insured loss equal to or greater than $300.0 million. Harleysville Group’s pooling share of this maximum recovery would be $140.4 million for any catastrophe involving an insured loss of $216.0 million or greater. The treaty includes reinstatement provisions providing for coverage for a second catastrophe and requiring payment of an additional premium in the event of a first catastrophe occurring. Most terrorism losses would not be covered by the treaty. Harleysville Group has not purchased funded catastrophe covers.

Casualty reinsurance (including liability and workers compensation subject to per-life maximums) is currently maintained under an excess of loss treaty affording recovery to $37.0 million above a retention of $3.0 million for each loss occurrence. Harleysville Group’s 2007 pooling share of a recovery would be up to $26.6 million above a retention of $2.2 million. In addition, there is reinsurance to protect Harleysville Group from large workers compensation losses on a per-life basis above a retention of $2.0 million. Harleysville Group’s pooling share of this retention would be $1.4 million. For umbrella liability coverages, reinsurance protection up to 75% of the first $4.0 million over a retention of $1.0 million and 100% of the next $5.0 million in excess of $5.0 million is provided. Harleysville Group’s 2007 pooling share would provide for a maximum recovery of $5.8 million over a retention of $0.7 million. The casualty reinsurance programs provide coverage for a terrorist event with no reinstatement provision.

The terms and charges for reinsurance coverage are typically negotiated annually. The reinsurance market is subject to conditions which are similar to those in the direct property and casualty insurance market, and there can be no assurance that reinsurance will remain available to Harleysville Group to the same extent and at the same cost currently maintained.

Harleysville Group considers numerous factors in choosing reinsurers, the most important of which are the financial stability and credit worthiness of the reinsurer. Harleysville Group has not experienced any material uncollectible reinsurance recoverables.

The Company’s subsidiaries and the Mutual Company are servicing carriers in the “Write-Your-Own” (WYO) program of the United States government’s National Flood Insurance Program (NFIP). The WYO program is a cooperative undertaking of the insurance industry and the Federal Emergency Management Agency. As servicing carriers, Harleysville Group and the Mutual Company bear no risk of loss on flood insurance policies. All of the premiums collected on flood insurance policies are ceded to the federal government and, in exchange a servicing fee is received from which agency commission, claim handling fees and other related expenses are paid.

As a writer of personal and commercial automobile policies in the state of Michigan, in compliance with applicable state regulations, Harleysville Group cedes premiums and claims for medical benefits and work loss, above a specified retention amount, to the Michigan Catastrophic Claims Association. For policies effective July 1, 2007 to June 30, 2008, the required retention is $420,000.



10



Competition. The property and casualty insurance industry is highly competitive on the basis of both price and service. There are numerous companies competing for the categories of business underwritten by Harleysville Group in the geographic areas where Harleysville Group operates, many of which are substantially larger and have considerably greater financial resources than Harleysville Group. In addition, because the insurance products of Harleysville Group and the Mutual Company are marketed exclusively through independent insurance agencies, most of which represent more than one company, Harleysville Group faces competition within each agency.

Marketing. Harleysville Group markets its insurance products through independent agencies and monitors the performance of these agencies relative to many factors including profitability, growth and retention. At December 31, 2007, there were approximately 1,500 agencies.

Investments

An important element of the financial results of Harleysville Group is the return on invested assets. An investment objective of Harleysville Group is to maintain a widely diversified fixed maturities portfolio structured to maximize after-tax investment income while minimizing credit risk through investments in high quality instruments. An objective also is to provide adequate funds to pay claims without forced sales of investments. At December 31, 2007, substantially all of Harleysville Group’s fixed maturity investment portfolio was rated investment grade and the investment portfolio did not contain any real estate or mortgage loans. Harleysville Group also invests in equity securities with the objective of capital appreciation.

Harleysville Group has adopted and follows an investment philosophy which precludes the purchase of non-investment grade fixed income securities. However, due to uncertainties in the economic environment, it is possible that the quality of investments held in Harleysville Group’s portfolio may change.

The following table shows the composition of Harleysville Group’s fixed maturity investment portfolio at amortized cost, excluding short-term investments and securities lending collateral, by rating as of December 31, 2007:

 

 

December 31, 2007

 

 

 

Amount

 

Percent

 

 

 

(dollars in thousands)

 

Rating(1)

 

 

 

 

 

 

 

U.S. Treasury and U.S. agency bonds (2) 

 

$

623,523

 

 

29.0

%

Aaa

 

 

666,038

 

 

31.0

 

Aa

 

 

467,125

 

 

21.8

 

A

 

 

344,756

 

 

16.1

 

Baa

 

 

26,309

 

 

1.2

 

Ba

 

 

15,567

 

 

0.7

 

B

 

 

3,991

 

 

0.2

 

Total

 

$

2,147,309

 

 

100.0

%

———————

(1)

Ratings assigned by Moody’s Investors Services, Inc.

(2)

Includes GNMA pass-through obligations and collateralized mortgage obligations.

Harleysville Group invests in both taxable and tax-exempt fixed income securities as part of its strategy to maximize after-tax income. Such strategy considers, among other factors, the impact of the alternative minimum tax. Tax-exempt bonds made up approximately 28%, 27% and 36% of the total investment portfolio at December 31, 2007, 2006 and 2005, respectively.



11



The following table shows the composition of Harleysville Group’s investment portfolio at carrying value, excluding short-term investments and securities lending collateral, by type of security as of December 31, 2007:

 

 

December 31, 2007

 

 

 

Amount

 

Percent

 

 

 

(dollars in thousands)

 

Fixed maturities:

 

 

 

 

 

 

 

U.S. Treasury obligations

 

$

84,307

 

 

3.7

%

U.S. agency obligations

 

 

177,149

 

 

7.9

 

Mortgage-backed securities

 

 

373,479

 

 

16.6

 

Obligations of states and political subdivisions

 

 

769,295

 

 

34.2

 

Corporate securities

 

 

770,005

 

 

34.2

 

Total fixed maturities

 

 

2,174,235

 

 

96.6

 

Equity securities

 

 

76,297

 

 

3.4

 

Total

 

$

2,250,532

 

 

100.0

%

Investment results of Harleysville Group’s fixed maturity investment portfolio are as shown in the following table:

 

 

Year Ended December 31,

 

 

 

2007

 

2006

 

2005

 

 

 

(dollars in thousands)

 

Invested assets(1)

 

$

2,123,708

 

$

1,954,158

 

$

1,733,086

 

Investment income(2)

 

$

105,861

 

$

95,101

 

$

86,463

 

Average yield

 

 

5.0

%

 

4.9

%

 

5.0

%

———————

(1)

Average of the aggregate invested amounts at amortized cost at the beginning and end of the period.

(2)

Investment income does not include investment expenses, realized investment gains or losses or provision for income taxes.

The following table indicates the composition of Harleysville Group’s fixed maturity investment portfolio at carrying value, excluding short-term investments and securities lending collateral, by time to maturity as of December 31, 2007:

 

 

December 31, 2007

 

 

 

Amount

 

Percent

 

 

 

(dollars in thousands)

 

Due in(1)

 

 

 

 

 

 

 

1 year or less

 

$

266,152

 

 

12.2

%

Over 1 year through 5 years

 

 

784,318

 

 

36.1

 

Over 5 years through 10 years

 

 

691,630

 

 

31.8

 

Over 10 years

 

 

58,656

 

 

2.7

 

 

 

 

1,800,756

 

 

82.8

 

Mortgage-backed securities

 

 

373,479

 

 

17.2

 

Total

 

$

2,174,235

 

 

100.0

%

———————

(1)

Based on stated maturity dates with no prepayment assumptions. Actual maturities may differ because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

The average expected life of Harleysville Group’s investment portfolio as of December 31, 2007 was approximately 4.7 years.

Regulation

Insurance companies are subject to supervision and regulation in the states in which they transact business. Such supervision and regulation relate to numerous aspects of an insurance company’s business and financial condition. The purpose of such supervision and regulation is the protection of policyholders. The extent of such supervision and regulation varies, but generally derives from state statutes which delegate regulatory, supervisory and



12



administrative authority to state insurance departments. Accordingly, the authority of the state insurance departments typically includes the establishment of standards of solvency which must be met and maintained by insurers, the licensing to do business of insurers and agents, the nature of and limitations on investments, the approval process for premium rates for property and casualty insurance, the provisions which insurers must make for current losses and future liabilities, the deposit of securities for the benefit of policyholders and the approval of policy forms. Such insurance departments also conduct periodic examinations of the affairs of insurance companies and require the filing of annual and other reports relating to the financial condition of insurance companies.

All of the states in which Harleysville Group and the Mutual Company do business have guaranty fund laws under which insurers doing business in such states can be assessed up to 2% of annual premiums written by the insurer in that state in order to fund policyholder liabilities of insolvent insurance companies. Under these laws in general, an insurer is subject to assessment, depending upon its market share of a given line of business, to assist in the payment of policyholder and third party claims against insolvent insurers.

State laws also require Harleysville Group to participate in involuntary insurance programs for automobile insurance, as well as other property and casualty lines, in states in which Harleysville Group writes such lines. These programs include joint underwriting associations, assigned risk plans, fair access to insurance requirements (FAIR) plans, reinsurance facilities and wind storm plans. These state laws generally require all companies that write lines covered by these programs to provide coverage (either directly or through reinsurance) for insureds who cannot obtain insurance in the voluntary market. The legislation creating these programs usually allocates a pro rata portion of risks attributable to such insureds to each company on the basis of direct written premiums or the number of automobiles insured. Generally, state law requires participation in such programs as a condition to doing business. The loss ratio on insurance written under involuntary programs generally has been greater than the loss ratio on insurance in the voluntary market.

State insurance holding company acts regulate insurance holding company systems. Each insurance company in the holding company system is required to register with the insurance supervisory agency of its state of domicile and furnish certain information concerning transactions between companies within the holding company system that may materially affect the operations, management or financial condition of the insurer within the system, including the payment of dividends from the insurance subsidiaries to the Company.

Insurance holding company acts require that all transactions involving any insurer within the holding company system, including those involving the Mutual Company and the Company’s insurance subsidiaries, must be fair and equitable to that insurer. Further, approval of the applicable insurance commissioner is required prior to the consummation of a transaction affecting the control of an insurer.

The Terrorism Risk Insurance Act of 2002 (the Act) established a program that provides a backstop for insurance-related losses resulting from any act of terrorism as defined. The Act, originally set to expire in 2005, was extended through December 31, 2007 in December 2005. The Act was extended again through December 31, 2014 in December 2007 and retitled as the Terrorism Risk Insurance Program Reauthorization Act (TRIPRA) of 2007. Under the program, the federal government will pay 85% of covered losses after an insurer’s losses exceed a deductible determined by a statutorily prescribed formula, up to a combined annual aggregate limit for the federal government and all insurers of $100 billion. If an act of terrorism or acts of terrorism result in covered losses exceeding the $100 billion annual limit, insurers with losses exceeding their deductibles will not be responsible for additional losses. The triggering threshold for certifying an act of terrorism is $100 million in 2007 through 2014. TRIPRA adds coverage for domestic acts of terror, in addition to foreign acts of terror covered under the previous act.

The statutory formula for determining a company’s deductible for each year is based on the company’s direct commercial earned premiums for the prior calendar year multiplied by a specified percentage. These percentages are 20% for 2007 through 2014. The following lines of business are excluded from coverage and are not to be included in the deductible calculation: commercial auto, burglary and theft, surety, professional liability and farmowners’ multiperil insurance. Based on the Company’s insurance subsidiaries 2007 earned premiums for lines subject to the Act, our 2008 deductible would be $102 million.

The Act and TRIPRA require all property and casualty insurers to make terrorism insurance coverage available in all of their covered commercial property and casualty insurance policies (as defined in the Act).



13



In the event the Act is not renewed beyond 2014, or is renewed in a materially different form, the Company may have to attempt to obtain appropriate reinsurance for the related terrorism risk, seek exclusion from coverage related to terrorism exposure from the appropriate regulatory authorities, limit certain of its writings, or pursue a solution encompassing aspects of one or more of the foregoing.

The insurance industry has received adverse publicity about alleged anti-competitive activities by certain insurance brokers and insurers. Harleysville Group primarily distributes its products through its agents and writes approximately 2% of its premiums through brokers.

The property and casualty insurance industry has been subject to significant public scrutiny and comment primarily due to concerns regarding solvency issues, rising insurance costs, and the industry’s methods of operations. Accordingly, regulations and legislation may be adopted or enacted: to provide a greater role for the federal government in regulation of insurance companies; to strengthen state oversight, particularly in the field of solvency and investments; to further restrict an insurer’s flexibility in underwriting and pricing risks; and to impose new taxes and assessments. It is not possible to predict whether, in what form or in what jurisdictions, any of these measures might be adopted or the effect, if any, on Harleysville Group.

The Company’s insurance subsidiaries generally are restricted by the insurance laws of their respective states of domicile as to the amount of dividends they may pay to the Company without the prior approval of the respective state regulatory authorities. Generally, the maximum dividend that may be paid by an insurance subsidiary during any year without prior regulatory approval is limited to a stated percentage of that subsidiary’s statutory surplus as of a certain date, or adjusted net income of the subsidiary, for the preceding year. Applying the current regulatory restrictions as of December 31, 2007, $112.2 million would be available for distribution to Harleysville Group Inc. after June 5, 2008 without prior approval. The Company’s insurance subsidiaries paid dividends to the Company of $63.0 million in 2007 and $15.0 million in 2005. No dividends were paid in 2006. An additional $54.6 million of dividends were declared in 2007 and remain unpaid at December 31, 2007.

Various states have adopted the National Association of Insurance Commissioners (NAIC) risk-based capital (RBC) standards that require insurance companies to calculate and report statutory capital and surplus needs based on a formula measuring underwriting, investment and other business risks inherent in an individual company’s operations. These RBC standards have not affected the operations of Harleysville Group since each of the Company’s insurance subsidiaries has statutory capital and surplus in excess of RBC requirements.

Harleysville Group is required to file financial statements for its subsidiaries, prepared by using statutory accounting practices, with state regulatory authorities. The adjustments necessary to reconcile net income and shareholders’ equity determined by using SAP to net income and shareholders’ equity determined in accordance with GAAP are as follows:

 

 

Net Income

Year Ended December 31,

 

Shareholders’ Equity

December 31,

 

 

 

2007

 

2006

 

2005

 

2007

 

2006

 

 

 

(in thousands)

 

SAP amounts

 

$

114,343

 

$

131,263

 

$

62,330

 

$

671,895

 

$

686,149

 

Adjustments:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Deferred policy acquisition costs

 

 

(363

)

 

(1,856

)

 

3,418

 

 

101,954

 

 

102,317

 

Deferred income taxes

 

 

(10,728

)

 

(13,120

)

 

(513

)

 

(1,078

)

 

10,361

 

Unrealized investment gains

 

 

 

 

 

 

 

 

 

 

 

27,325

 

 

5,262

 

Pension

 

 

1,573

 

 

118

 

 

(1,701

)

 

(7,445

)

 

(18,251

)

Non-admitted assets

 

 

 

 

 

 

 

 

 

 

 

6,260

 

 

5,987

 

Other, net

 

 

(2,853

)

 

(5,006

)

 

(1,276

)

 

8,574

 

 

8,486

 

Holding company(1)

 

 

(1,918

)

 

(330

)

 

(827

)

 

(48,644

)

 

(88,149

)

GAAP amounts

 

$

100,054

 

$

111,069

 

$

61,431

 

$

758,841

 

$

712,162

 

———————

(1)

Represents the GAAP loss and equity amounts for Harleysville Group Inc., excluding the earnings of and investment in subsidiaries.



14



Business - Relationship with the Mutual Company

Harleysville Group’s operations are interrelated with the operations of the Mutual Company due to the pooling arrangement and other factors. The Mutual Company owned approximately 53% of the issued and outstanding common stock of Harleysville Group Inc. at December 31, 2007. Harleysville Group employees provide a variety of services to the Mutual Company and its wholly owned subsidiaries. The cost of facilities and employees required to conduct the business of both companies is charged on a cost-allocated basis. Harleysville Group also manages the operations of the Mutual Company and its wholly owned subsidiaries pursuant to a management agreement which commenced January 1, 1993 under which Harleysville Group receives a management fee. Harleysville Group received
$6.3 million, $6.4 million, and $6.7 million for the years ended December 31, 2007, 2006 and 2005, respectively, for all such management services.

All of the Company’s officers are officers of the Mutual Company, and six of the Company’s nine directors are directors of the Mutual Company. A coordinating committee exists to review and evaluate the pooling agreement and other material transactions between Harleysville Group and the Mutual Company and is responsible for matters involving actual or potential conflicts of interest between the two companies. The coordinating committee currently consists of seven non-employee directors, three from Harleysville Group Inc. and three from the Mutual Company all of whom are not members of both Boards and one, a non-voting Chairman, who is a member of both Boards. The decisions of the coordinating committee are binding on the two companies. No intercompany transaction can be authorized by the coordinating committee unless the Company’s committee members conclude that such transaction is fair and equitable to Harleysville Group.

The Mutual Company leases the home office from a company subsidiary and it shares most of the facility with Harleysville Group. Rental income under the lease was $4.1 million for 2007 and 2006, and $4.0 million for 2005. Harleysville Group believes that the lease terms are no less favorable to it than if the property were leased to a non-affiliate.

In connection with the acquisition of Mid-America and HIC New York, the Company borrowed approximately $18.5 million from the Mutual Company. See Note 7 of the Notes to Consolidated Financial Statements. For additional information with respect to transactions with the Mutual Company, see Note 2 of the Notes to Consolidated Financial Statements.

Employees

All employees are paid by Harleysville Group Inc. and, accordingly, are considered to be employees of Harleysville Group Inc. As of December 31, 2007, there were 1,800 employees. They provide a variety of services to the Mutual Company and its wholly owned subsidiaries. See “Business-Relationship with the Mutual Company” and Note 2 of the Notes to Consolidated Financial Statements.

Available Information

The Company maintains a website at www.harleysvillegroup.com. Our annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to those reports, filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, are available free of charge on our website as soon as practicable after electronic filing of such material with, or furnishing it to, the Securities and Exchange Commission.

Item 1A.

Risk Factors.

For a discussion of risk factors, see “Management’s Discussion and Analysis - Risk Factors.”

Item 1B.

Unresolved Staff Comments.

None.



15



Item 2.

Properties.

The buildings which house the headquarters of Harleysville Group and the Mutual Company are leased to the Mutual Company by a subsidiary of Harleysville Group. See “Business-Relationship with the Mutual Company.” The Mutual Company charges Harleysville Group for an appropriate portion of the rent under an intercompany allocation agreement. The buildings containing the headquarters of Harleysville Group and the Mutual Company have approximately 220,000 square feet of office space. Harleysville Group also rents office facilities in certain of the states in which it does business.

Item 3.

Legal Proceedings.

Harleysville Group is a party to numerous lawsuits arising in the ordinary course of its insurance business. Harleysville Group believes that the resolution of these lawsuits will not have a material adverse effect on its financial condition and results of operations.

Item 4.

Submission of Matters to a Vote of Security Holders.

No matter was submitted to a vote of the security holders during the fourth quarter of 2007.



16



PART II

Item 5.

Market for Registrant’s Common Stock, Related Stockholder Matters and Issuer Purchases of Equity Securities.

The stock of Harleysville Group Inc. is quoted on the Nasdaq National Market System, and assigned the symbol HGIC. At the close of business on March 3, 2008, the approximate number of holders of record of Harleysville Group Inc.’s common stock was 2,927 (counting all shares held in single nominee registration as one shareholder).

The payment of dividends is subject to the discretion of Harleysville Group Inc.’s Board of Directors which considers, among other factors, Harleysville Group’s operating results, overall financial condition, capital requirements and general business conditions each quarter. The present quarterly dividend of $0.25 per share paid in each of the third and fourth quarters of 2007 is expected to continue during 2008. As a holding company, one of Harleysville Group Inc.’s sources of cash with which to pay dividends is dividends from its subsidiaries. Harleysville Group Inc.’s insurance company subsidiaries are subject to state laws that restrict their ability to pay dividends. See Note 8 of the Notes to Consolidated Financial Statements.

The following table sets forth the amount of cash dividends declared per share, and the high and low bid quotations as reported by Nasdaq for Harleysville Group Inc.’s common stock for each quarter during the past two years.

 

 

High

 

Low

 

Cash

Dividends

Declared

 

2007

 

 

 

 

 

 

 

 

 

 

First Quarter

 

$

35.58

 

$

31.50

 

$

.19

 

Second Quarter

 

 

34.12

 

 

29.99

 

 

.19

 

Third Quarter

 

 

34.66

 

 

27.96

 

 

.25

 

Fourth Quarter 

 

 

37.83

 

 

30.90

 

 

.25

 

 

 

 

 

 

 

 

 

 

 

 

 

 

High

 

Low

 

Cash

Dividends

Declared

 

2006

 

 

 

 

 

 

 

 

 

 

First Quarter

 

$

30.14

 

$

26.19

 

$

.175

 

Second Quarter

 

 

31.66

 

 

27.50

 

 

.175

 

Third Quarter

 

 

36.21

 

 

31.36

 

 

.19

 

Fourth Quarter

 

 

38.68

 

 

34.74

 

 

.19

 

Securities Authorized for Issuance Under Equity Plans. See “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters,” which is incorporated by reference to our definitive Proxy Statement for our annual meeting of stockholders to be held on April 23, 2008, which shall be filed with the SEC within 120 days after the end of our fiscal year.

Unregistered Sales of Equity Securities and Use of Proceeds.

None.

Issuer Purchases of Equity Securities (1)


 

Period

 

Total Number

of Shares

Purchased (2)

 

Average Price

Paid Per Share

 

Total Number of

Shares Purchased

as Part of Publicly

Announced Plans

or Programs

 

Maximum Number

of Shares that
May Yet Be Purchased
Under the Program

 

 

  

   

 

   

 

   

 

   

 

 

 

October 1 - October 31, 2007

 

53,402

 

$31.01

 

53,402

 

1,318,990

 

 

November 1 - November 30, 2007

 

54,429

 

$31.01

 

54,429

 

1,264,561

 

———————

(1)

In June 2007, the Board of Directors authorized the Company to repurchase up to 1.6 million shares of its outstanding common stock for a two year period in the open market or in privately negotiated transactions. The Company was authorized to repurchase shares from Harleysville Mutual Insurance Company (Mutual), which owns 53% of the



17



Company’s stock, at fair market value terms on the date of purchase and from the public float in amounts that are proportional to the respective ownership percentages of Mutual and the public float as of the authorization date. This program was completed on July 18, 2007. On August 1, 2007, the Board of Directors authorized the Company to repurchase an additional 1.6 million shares of its outstanding common stock for a two year period in the open market or in privately negotiated transactions. The Company is authorized to repurchase shares from Mutual at fair market value terms on the date of purchase and from the public float in amounts that are proportional to the respective ownership percentages of Mutual and the public float as of the authorization date. All such repurchases were effected under Rule 10b5-1 plans.

(2)

Represents the total number of shares repurchased during the period, of which 107,831 of these shares were settled for cash on or before December 31, 2007.

Stock Performance Chart.

The following graph shows changes over the past five-year period (all full calendar-year periods) in the value of $100 invested in: 1) Harleysville Group common stock; 2) the NASDAQ Stock Market index; and 3) the Peer Group index. All values are as of the last trading day of each year.

Comparison of 5-Year Cumulative Total Stockholder Return

[harleysville10k002.gif]


 

2002

2003

2004

2005

2006

2007

Harleysville Group Inc.

100.0

 77.5

 96.1

110.0

148.0

154.5

NASDAQ

100.0

149.5

162.7

166.2

182.6

198.0

Peer Group

100.0

123.6

149.7

168.1

191.1

188.8



18



The year-end values of each investment shown in the preceding graph are based on share price appreciation plus dividends, with the dividends reinvested as of the day such dividends were ex-dividend. The calculations exclude trading commissions and taxes. Total stockholder returns from each investment, whether measured in dollars or percentages, can be calculated from the year-end investment values shown in the legend.

The graph was prepared by the Center for Research in Security Prices (CRSP). The NASDAQ National Market System index includes all U.S. Companies in the NASDAQ National Market System and Peer Group index includes 55 NASDAQ Company stocks in SIC Major Group 633 (SIC 6330-6339: U.S. and foreign, fire, marine and casualty insurance). A complete list of these companies may be obtained from CRSP at the University of Chicago Graduate School of Business, 1101 East 58th Street, Chicago, Illinois 60637; (773) 702-7467. CRSP reweights the indices daily, using the market capitalization on the previous trading day.

Item 6.

Selected Financial Data.

At December 31, 2007, Harleysville Group Inc. (Company) was approximately 53% owned by Harleysville Mutual Insurance Company (the Mutual Company). Harleysville Group Inc. and its wholly owned subsidiaries (collectively, Harleysville Group) are engaged in property and casualty insurance. These subsidiaries are: Harleysville-Atlantic Insurance Company, Harleysville Insurance Company, Harleysville Insurance Company of New Jersey, Harleysville Insurance Company of New York, Harleysville Insurance Company of Ohio, Harleysville Lake States Insurance Company, Harleysville Preferred Insurance Company, Harleysville Worcester Insurance Company, Mid-America Insurance Company (which was merged into Harleysville Worcester Insurance Company in 2007), and Harleysville Ltd., a real estate partnership that owns the home office.

 

 

Year Ended December 31,

 

 

 

2007

 

2006

 

2005

 

2004

 

2003

 

 

 

(in thousands, except per share data)

 

Income Statement Data(1):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Premiums earned

 

$

833,024

 

$

838,821

 

$

841,567

 

$

837,665

 

$

823,407

 

Investment income, net

 

 

110,827

 

 

102,609

 

 

90,572

 

 

87,171

 

 

86,597

 

Realized investment gains (losses)

 

 

875

 

 

40,605

 

 

233

 

 

12,667

 

 

(920

)

Total revenues

 

 

962,012

 

 

999,171

 

 

948,340

 

 

953,392

 

 

924,965

 

Income (loss) before income taxes

 

 

142,995

 

 

156,368

 

 

78,921

 

 

55,637

 

 

(89,450

)

Income taxes (benefit)

 

 

42,941

 

 

46,241

 

 

17,490

 

 

8,759

 

 

(41,821

)

Net income (loss)

 

 

100,054

 

 

111,069

 

 

61,431

 

 

46,878

 

 

(47,629

)

Basic earnings (loss) per share

 

$

3.24

 

$

3.58

 

$

2.02

 

$

1.56

 

$

(1.59

)

Diluted earnings (loss) per share

 

$

3.19

 

$

3.52

 

$

2.01

 

$

1.55

 

$

(1.59

)

Cash dividends per share

 

$

.88

 

$

.73

 

$

.69

 

$

.68

 

$

.67

 

Balance Sheet Data at Year End:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total investments

 

$

2,358,473

 

$

2,249,014

 

$

2,064,388

 

$

1,966,917

 

$

1,854,633

 

Total assets

 

 

3,072,445

 

 

2,990,984

 

 

2,905,266

 

 

2,718,063

 

 

2,680,389

 

Debt

 

 

118,500

 

 

118,500

 

 

118,500

 

 

119,625

 

 

120,145

 

Shareholders’ equity

 

 

758,841

 

 

712,162

 

 

614,383

 

 

587,924

 

 

572,747

 

Shareholders’ equity per share

 

$

25.03

 

$

22.49

 

$

20.07

 

$

19.47

 

$

19.16

 

———————

(1)

The Company’s insurance subsidiaries participate in an underwriting pooling arrangement with the Mutual Company. Harleysville Group’s participation was 72% for all years presented. See “Management’s Discussion and Analysis of Results of Operations and Financial Condition” and Note 2(a) of the Notes to Consolidated Financial Statements.



19



Item 7.

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

Certain of the statements contained herein (other than statements of historical facts) are forward-looking statements. Such forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and include estimates and assumptions related to economic, competitive, legislative and regulatory developments. These forward-looking statements are subject to change and uncertainty which are, in many instances, beyond the Company’s control and have been made based upon management’s expectations and beliefs concerning future developments and their potential effect on Harleysville Group. There can be no assurance that future developments will be in accordance with management’s expectations or that the effect of future developments on Harleysville Group will be those anticipated by management. Actual financial results, including premium levels and underwriting results, could differ materially from those anticipated by Harleysville Group depending on the outcome of certain factors, which may include changes in property and casualty loss trends and reserves; catastrophe losses; competition in insurance product pricing; government regulation and changes therein which may impede the ability to charge adequate rates; performance of the financial markets; fluctuations in interest rates; availability and price of reinsurance; the A. M. Best rating of Harleysville Group; and the status of labor markets in which the Company operates. In addition, see “Management’s Discussion and Analysis - Risk Factors.”

Overview

The Company’s net income is primarily determined by three elements:

·

net premium income

·

investment income

·

amounts paid or reserved to settle insured claims

Variations in premium income are subject to a number of factors, including

·

limitations on premium rates arising from the competitive market place or regulation

·

limitations on available business arising from a need to maintain the quality of underwritten risks

·

the Company’s ability to maintain its A- (“excellent”) rating by A.M. Best

·

the ability of the Company to maintain a reputation for efficiency and fairness in claims administration

Variations on investment income are subject to a number of factors, including

·

general interest rate levels

·

specific adverse events affecting the issuers of debt obligations held by the Company

·

changes in the prices of equity securities generally and those held by the Company specifically

Loss and loss settlement expenses are affected by a number of factors, including

·

the quality of the risks underwritten by the Company

·

the nature and severity of catastrophic losses

·

the availability, cost and terms of reinsurance

·

underlying settlement costs, including medical and legal costs

The Company seeks to manage each of the foregoing to the extent within its control. Many of the foregoing factors are partially, or entirely, outside of the control of the Company.



20



Critical Accounting Policies and Estimates

The consolidated financial statements are prepared in conformity with U.S. generally accepted accounting principles, which require Harleysville Group to make estimates and assumptions (see Note 1 of the Notes to Consolidated Financial Statements). Harleysville Group believes that of its significant accounting policies, the following may involve a higher degree of judgment and estimation. The judgments, or the methodology on which the judgments are made, are reviewed quarterly with the Audit Committee.

Liabilities for Losses and Loss Settlement Expenses. The liability for losses and loss settlement expenses represents estimates of the ultimate unpaid cost of all losses incurred, including losses for claims which have not yet been reported to Harleysville Group. The amount of loss reserves for reported claims is based primarily upon a case-by-case evaluation of the type of risk involved, knowledge of the circumstances surrounding each claim and the insurance policy provisions relating to the type of loss. The amounts of loss reserves for unreported claims and loss settlement expense reserves are determined utilizing historical information by line of insurance as adjusted to current conditions. Inflation is implicitly provided for in the reserving function through analysis of costs, trends and reviews of historical reserving results. Estimates of the liabilities are reviewed and updated on a regular basis using the most recent information on reported claims and a variety of actuarial techniques. It is expected that such estimates will be more or less than the amounts ultimately paid when the claims are settled. Changes in these estimates are reflected in current operations.

Investments. Generally, unrealized investment gains or losses on investments carried at fair value, net of applicable income taxes, are reflected directly in shareholders’ equity as a component of comprehensive income and, accordingly, have no effect on net income. However, if the fair value of an investment declines below its cost and that decline is deemed other than temporary, the amount of the decline below cost is charged to earnings. Harleysville Group monitors its investment portfolio and at least quarterly reviews investments that have experienced a decline in fair value below cost to evaluate whether the decline is other than temporary. Such evaluations consider, among other things, the magnitude and reasons for a decline, the prospects for the fair value to recover in the near term and Harleysville Group’s ability and intent to retain the investment for a period of time sufficient to allow for a recovery in value. Future adverse investment market conditions, or poor operating results of underlying investments, could result in an impairment charge in the future.

Harleysville Group has written down to fair value, without exception, any equity security that has declined below cost by more than 20% and maintained such decline for six months, or by 50% or more, in the quarter in which either such decline occurred. In some cases, securities that have declined by a lesser amount or for a shorter period of time are written down if the evaluation indicates the decline is other than temporary. Fair value of equity securities is based on the closing market value. The fair value of mutual fund holdings is based on the closing net asset value reported by the fund. The fair value of fixed maturities is based upon data supplied by an independent pricing service. It can be difficult to determine the fair value of non-traded securities but Harleysville Group does not own a material amount of non-traded securities.

Policy Acquisition Costs. Policy acquisition costs, such as commissions, premium taxes and certain other underwriting and agency expenses that vary with and are primarily related to the production of business, are deferred and amortized over the effective period of the related insurance policies and in proportion to the premiums earned. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. The estimation of net realizable value takes into account the premium to be earned, related investment income over the claim paying period, expected losses and loss settlement expenses, and certain other costs expected to be incurred as the premium is earned. Future changes in estimates, the most significant of which is expected losses and loss settlement expenses, may require adjustments to deferred policy acquisition costs. If the estimation of net realizable value indicates that the acquisition costs are unrecoverable, further analyses are completed to determine if a reserve is required to provide for losses that may exceed the related unearned premiums.

Contingencies. Besides claims related to its insurance products, Harleysville Group is subject to proceedings, lawsuits and claims in the normal course of business. Harleysville Group assesses the likelihood of any adverse outcomes to these matters as well as potential ranges of probable losses. There can be no assurance that actual outcomes will be consistent with those assessments.

The application of certain of these critical accounting policies to the years ended December 31, 2007 and 2006 is discussed in greater detail below.



21



Results of Operations

Harleysville Group underwrites property and casualty insurance in both the personal and commercial lines of insurance. The personal lines of insurance include both auto and homeowners, and the commercial lines include auto, commercial multi-peril and workers compensation. The business is marketed primarily in the eastern and midwestern United States through independent agents.

Historically, Harleysville Group’s results of operations have been influenced by factors affecting the property and casualty insurance industry in general. The operating results of the United States property and casualty insurance industry have been subject to significant variations due to competition, weather, catastrophic events, regulation, the availability and cost of satisfactory reinsurance, general economic conditions, judicial trends, fluctuations in interest rates and other changes in the investment environment.

Harleysville Group’s premium growth and underwriting results have been, and continue to be, influenced by market conditions. Insurance industry price competition has often made it difficult both to obtain and to retain properly priced personal and commercial lines business. It is management’s policy to continue to maintain its underwriting standards.

The key elements of Harleysville Group’s business model are the sales of properly priced and underwritten personal and commercial property and casualty insurance through independent agents and the investment of the premiums in a manner designed to assure that claims and expenses can be paid while providing a return on the capital employed. Loss trends and investment performance are critical factors in influencing the success of the business model. These factors are affected by the factors impacting the insurance industry in general as described above and factors unique to Harleysville Group as described in the following discussion.

Transactions with Affiliates

The Company’s property and casualty subsidiaries participate in a pooling agreement with the Mutual Company. The pooling agreement provides for the allocation of premiums, losses, loss settlement expenses and underwriting expenses between Harleysville Group and the Mutual Company. Harleysville Group is not liable for any losses incurred by the Mutual Company, Preferred and HNJ prior to January 1, 1986, the date the pooling agreement became effective. Harleysville Group’s participation in the pool has been 72% since January 1, 1998.

Effective January 1, 2008, the Company’s property and casualty subsidiaries and the Mutual Company and its property and casualty subsidiary, Harleysville Pennland Insurance Company (Pennland) amended their intercompany pooling agreement to increase Harleysville Group’s share of the pool from 72% to 80%. Harleysville Group received cash and investments of $192.1 million on January 3, 2008 associated with the transfer of assets and liabilities from the Mutual Company and Pennland to Harleysville Group in connection with the pool change.

When the Company’s subsidiaries’ pooling participation increases, there is a larger retrocession of this pooled business from the Mutual Company. Through this retrocession, Harleysville Group is assuming a larger share of premiums, losses and underwriting expenses for current and future periods originating both from its subsidiaries and the Mutual Company. An increase in Harleysville Group’s pooling participation results in a larger share of the pooled liabilities being assumed by Harleysville Group. Cash and investments are received by Harleysville Group equal to this greater share of loss reserves, unearned premiums and other insurance liabilities (primarily commissions and premium taxes) less a ceding commission based on acquisition costs related to unearned premiums. An increase in pool participation also increases Harleysville Group’s leverage and exposure to prior period development.

Because the pooling agreement does not relieve Harleysville Group of primary liability as the originating insurer, there is a concentration of credit risk arising from business ceded to the Mutual Company. However, the pooling agreement provides for the right of offset and the amount of credit risk with the Mutual Company was not material at December 31, 2007 and 2006, and is not expected to be materially different after the pool change effective January 1, 2008. The Mutual Company has an A. M. Best rating of “A-” (Excellent).

Harleysville Group has attempted to reduce the potential impact of future catastrophes by achieving greater geographic distribution of risks, reducing exposure in catastrophe-prone areas and through reinsurance, including an agreement with the Mutual Company. Effective January 1, 1997, Harleysville Group entered into a reinsurance agreement with Mutual Company whereby the Mutual Company, in return for a reinsurance premium, reinsured accumulated catastrophe losses up to $14.4 million in a quarter for 2005. This reinsurance coverage was in excess of a retention of $3.6 million in a quarter for 2005. The agreement excluded catastrophe losses resulting from earthquakes,



22



terrorism or hurricanes, and supplemented the existing external catastrophe reinsurance program. The premiums for this reinsurance were established in consultation with an independent actuarial firm. The agreement was terminated December 31, 2005 and coverage was not placed as it is no longer deemed necessary based on the current catastrophe risk profile. Under this agreement, Harleysville Group ceded premiums earned of $8.8 million and losses incurred of $(0.2) million to the Mutual Company in 2005.

Harleysville Ltd. is a subsidiary of the Company and leases the home office to the Mutual Company, which shares the facility with Harleysville Group. Rental income under the lease was $4.1 million, $4.1 million and $4.0 million for 2007, 2006 and 2005, respectively, and is included in other income after elimination of intercompany amounts of $2.5 million in 2007, $2.5 million in 2006 and $2.4 million in 2005. The lease has a five-year term expiring December 31, 2009 and includes a formula for additional rent for any additions, improvements or renovations. The Mutual Company is responsible for the building operating expenses including maintenance and repairs. The pricing of the lease was based upon an appraisal obtained from an independent real estate appraiser.

Harleysville Group provides certain management services to the Mutual Company and other affiliates. Harleysville Group received a fee of $6.3 million, $6.4 million and $6.7 million in 2007, 2006 and 2005, respectively, for its services under these management agreements. Under related agreements, Harleysville Group serves as the paymaster for Harleysville companies, with each company being charged for its proportionate share of salary and employee benefits expense based upon time allocation. The level of fees has been approved by each state insurance department having jurisdiction.

The Company’s insurance subsidiaries and the Mutual Company are party to an Equipment and Supplies Allocation Agreement whereby equipment and supplies are shared between parties. Ultimate expense for such items is allocated to Harleysville Group based on its pooling participation. The Mutual Company has purchased and developed certain equipment and software which is expensed by Harleysville Group based on its pooling participation as the items are depreciated or amortized.

Intercompany balances are created primarily from the pooling arrangement (settled quarterly), allocation of common expenses, collection of premium balances and payment of claims (settled monthly). No interest is charged or received on intercompany balances due to the timely settlement terms and nature of the items.

Harleysville Group borrowed $18.5 million from the Mutual Company in connection with the acquisition of Mid-America and HIC New York in 1991. It was a demand loan with a stated maturity in March 1998 which had been extended to March 2005. In February 2005, the maturity was extended again to March 2012 and the interest rate became LIBOR plus 0.45%, which was a commercially reasonable market rate in 2005. Interest expense on this loan was $1.1 million, $1.0 million and $0.7 million in 2007, 2006 and 2005, respectively.

Harleysville Group has no material relationships with current or former members of management other than compensatory plans and arrangements disclosed or described in the Company’s public filings.

Off Balance Sheet Arrangements

Harleysville Group has off-balance-sheet credit risk related to approximately $78.0 million and $77.0 million of premium balances due to the Mutual Company from agents and insureds at December 31, 2007 and 2006, respectively. The Mutual Company bills and collects such receivables on behalf of Harleysville Group for efficiency reasons. Harleysville Group recognizes any associated bad debts, which have not been material.

2007 Compared to 2006

Premiums earned decreased $5.8 million for the year ended December 31, 2007. The decrease was primarily composed of a decrease in premiums earned for commercial lines of $3.7 million and a decrease of $2.1 million in personal lines premiums earned. The decrease in premiums earned for commercial lines was primarily due to a decrease in commercial auto premiums earned due to fewer policy counts and a decrease in earned premiums assumed from involuntary pools. The decline in premiums earned for personal lines was primarily due to fewer policy counts. The reduction in personal lines volume was driven primarily by a reduction of personal automobile business from the continued implementation of more stringent underwriting processes, partially offset by an increase in homeowners business due to higher average premiums.



23



Investment income increased $8.2 million for the year ended December 31, 2007, resulting from an increase in invested assets and a greater percentage of invested assets in fixed maturity securities.

Net realized investment gains decreased $39.7 million for the year ended December 31, 2007, primarily due to gains on the sale of equity securities in the second quarter of 2006.

There were impairment charges of $1.4 million in 2007 and no impairment charges in 2006.

In April 2007, bonds with an amortized cost of $1,882,000 were transferred from the held to maturity category to the available for sale category due to a significant deterioration in the credit worthiness of the issuer. An impairment loss of $118,000 was recognized on this security. The security was sold in the third quarter of 2007 at a gain of $76,000.

Harleysville Group holds securities with unrealized losses at December 31, 2007 as follows:

 

 

Fair Value

 

Unrealized

Loss

 

Length of Unrealized Loss

 

Less Than

12 Months

 

Over 12

Months

 

 

(in thousands)

 

Fixed maturities:

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. Treasury securities and
obligations of U.S. government
corporations and agencies 

 

$

19,022

 

$

79

 

$

24

 

$

55

 

Obligations of states and political
subdivisions

 

 

104,500

 

 

914

 

 

66

 

 

848

 

Corporate securities

 

 

278,961

 

 

4,323

 

 

1,898

 

 

2,425

 

Mortgage-backed securities

 

 

123,788

 

 

1,674

 

 

570

 

 

1,104

 

Total fixed maturities

 

$

526,271

 

$

6,990

 

$

2,558

 

$

4,432

 

Equity securities

 

$

7,861

 

$

241

 

$

241

 

 

 

 


Of the total fixed maturity securities with an unrealized loss at December 31, 2007, securities with a fair value of $424.0 million and an unrealized loss of $5.9 million are classified as available for sale and are carried at fair value on the balance sheet while securities with a fair value of $102.3 million and an unrealized loss of $1.1 million are classified as held to maturity on the balance sheet and are carried at amortized cost.

The fixed maturity investments with continuous unrealized losses for less than twelve months were primarily due to a widening of credit spreads rather than a decline in credit quality. There are $323.1 million in fixed maturity securities, at fair value, that at December 31, 2007, had been below amortized cost for over twelve months. The $4.4 million of unrealized losses on such securities primarily relates to securities which carry investment grade ratings and have declined in fair value roughly in line with market interest rate changes. Harleysville Group currently has the ability and intent to hold these securities at least until recovery.

There are four positions that comprise the unrealized loss in equity investments at December 31, 2007. They have not been below cost for significant continuous amounts of time. Harleysville Group has been monitoring these securities and it is possible that some may be written down in the income statement in the future.

Income before income taxes and cumulative effect of accounting change decreased $13.4 million for the year ended December 31, 2007 compared to the prior year. The decrease was primarily due to a decrease in realized investment gains, partially offset by the increase in investment income and improved underwriting results.

The improved underwriting results in 2007 were primarily due to lower loss severity, lower catastrophe losses and lower underwriting expenses.

An insurance company’s statutory combined ratio is a standard measure of underwriting profitability. This ratio is the sum of (1) the ratio of incurred losses and loss settlement expenses to net earned premium, (2) the ratio of expenses incurred for commissions, premium taxes, administrative and other underwriting expenses to net written premium, and (3) the ratio of dividends to policyholders to net earned premium. The combined ratio does not reflect investment income, federal income taxes or other non-operating income or expense. A ratio of less than 100 percent generally indicates underwriting profitability. Harleysville Group’s statutory combined ratio decreased to 96.7% for the



24



year ended December 31, 2007 from 98.6% for the year ended December 31, 2006. Such decrease was due to improved underwriting results in commercial lines, partially offset by a lower underwriting gain in personal lines.

The statutory combined ratios by line of business for the year ended December 31, 2007 as compared to the year ended December 31, 2006 were as follows:

 

 

For the Year Ended

December 31,

 

 

 

2007

 

2006

 

Commercial: 

 

 

 

 

 

 

 

Automobile

 

 

94.7%

 

 

99.3%

 

Workers compensation

 

 

112.2%

 

 

117.2%

 

Commercial multi-peril

 

 

97.8%

 

 

98.9%

 

Other commercial

 

 

83.8%

 

 

86.6%

 

Total commercial

 

 

97.5%

 

 

100.3%

 

Personal:

 

 

 

 

 

 

 

Automobile

 

 

99.7%

 

 

99.3%

 

Homeowners

 

 

86.8%

 

 

82.6%

 

Other personal

 

 

79.8%

 

 

69.8%

 

Total personal

 

 

92.7%

 

 

90.6%

 

Total personal and commercial

 

 

96.7%

 

 

98.6%

 

The commercial lines statutory combined ratio decreased to 97.5% for the year ended December 31, 2007 from 100.3% for the year ended December 31, 2006. The decrease is primarily due to declines in the combined ratio for all lines of business. Favorable prior accident year development as well as improved underwriting results in the current accident year contributed to the decreases in the commercial auto and commercial multi-peril lines of business. The decrease in the commercial auto combined ratio was primarily due to the recognition of favorable development of $10.2 million in 2007, while favorable development of $5.1 million was recognized in 2006. The decrease in the commercial multi-peril combined ratio was due to improved underwriting results in the current accident year. The decrease in the workers compensation combined ratio was primarily due to improved underwriting results in the current accident year.

The personal lines statutory combined ratio increased to 92.7% for the year ended December 31, 2007 from 90.6% for the year ended December 31, 2006 primarily due to less favorable underwriting results in the current accident year.

Reserves for unpaid losses and loss settlement expenses are estimated for case reserves and losses incurred but not reported (IBNR) separately. The sum of case reserves and IBNR represents the Company’s estimate of total unpaid loss and loss settlement expense. Case reserves are determined for each reported claim by the Company’s claims organization reflecting the known circumstances of the individual claim. The Company’s actuaries calculate IBNR by reducing their estimate of ultimate loss and loss settlement expense by cumulative paid loss and loss settlement expense and case reserves. Ultimate losses are re-estimated for each line of business on a quarterly basis using the most current loss and claim data as of the quarter end.

In addition to analyzing reserves on a line of business basis, reserving categories are identified and reviewed. For example, the following categories for the Commercial Auto Liability line of business are analyzed quarterly: Commercial Auto Liability Bodily Injury; Commercial Auto Liability Property Damage; and Commercial Auto Liability Excess. In the discussion that follows, these categories are referred to by the label “line of business.”

In the course of our quarterly reserve estimation process, several standard loss reserving methods and procedures are utilized to derive estimates of ultimate loss for each line of business, including:

·

Paid Loss Development Method

·

Incurred Loss Development Method

·

Incurred Counts and Averages Method (Based on Exponential Fit of Severity)

·

Bornhuetter-Ferguson Method



25



Any individual method used to estimate loss reserves has its advantages and disadvantages based on trends, changes within the external business environment, changes in internal company processes and procedures and any bias that may be inherent in the methodology. The actuaries give consideration to the relative strengths and weaknesses of each of the methods to derive a selected point estimate within the range. Following is a general description of each of the methods used:

·

Paid Loss Development Method: The Paid Loss Development Method uses historical payment patterns to project future payments as of a given evaluation date to ultimate loss. Estimates using this method are not affected by changes in case reserving practices that might have occurred during the review period, but may be understated as this method does not take into account large unpaid claims. This method is also susceptible to any changes in the rate of claim settlements or shifts in the size of claims settled.

A number of indications of ultimate loss may be produced from the Paid Loss Development Method since a number of loss development factors (LDFs) may be selected. The actuaries produce and review several indications of ultimate loss using this method based on various LDF selections as judged appropriate, such as

·

3-Year Average (straight average and loss-weighted average)

·

5-Year Average (straight average and loss-weighted average)

·

5-Year Excluding Highest and Lowest LDFs

·

All-Year loss-weighted average

·

Selected LDF Pattern (LDFs are selected for each evaluation based on the actuaries’ review of the historical development)

·

Incurred Loss Development Method: The Incurred Loss Development Method is similar to the paid method, but instead uses historical incurred (case reserves plus payments) patterns to project future incurred losses as of a given evaluation date to ultimate loss. In many cases, the incurred development method is preferred over the paid method as it includes the additional information provided by the aggregation of individual case reserves. The resulting LDFs tend to be lower and more stable than those of the paid development method. However, the incurred development method may be affected by changes in case reserving practices and any unusually large individual claims.

As with the Paid Loss Development Method, various indications of ultimate loss may be produced from the Incurred Loss Development Method. The actuaries produce and review several indications of ultimate loss using this method based on various LDF selections.

·

Incurred Counts and Averages Method: This method is used to estimate ultimate loss by separately estimating ultimate counts and severity (average loss per claim) components of ultimate loss. Both the ultimate claim counts and ultimate severity are estimated using a loss development factor approach similar to the Incurred Loss Development Method. For this reason, the same considerations discussed in the Incurred Loss Development Method apply to this method as well.

An ultimate severity is selected by fitting an exponential curve to the historical ultimate severities indicated using the ratio of the ultimate loss and ultimate claim counts. This method yields ultimate severities that are based on the underlying historical trends in the data. Ultimate claim counts and ultimate severities are multiplied together to produce an estimate of ultimate losses.

This method is useful in more recent accident years where the data is not mature and is especially useful when loss development patterns are volatile or not well established.

·

Bornhuetter-Ferguson Method: The Bornhuetter-Ferguson Method is a blended method that explicitly takes into account both actual loss development to date and expected future loss emergence. Two versions of this method exist: one based on paid loss and one based on incurred loss. This method uses the selected loss development patterns from the Development Methods to calculate the expected percentage of loss unpaid (or unreported). The expected component of the method is calculated by multiplying earned premium for the given exposure period by a selected a priori loss ratio. The resulting dollars are then



26



multiplied by the expected percentage of unpaid (or unreported) loss described above. This provides an estimate of future loss payments (or reporting) that is then added to actual paid (or incurred) loss data to produce estimated ultimate loss.

Each of the methodologies described above (and their derivatives) are reviewed for each line of business. This approach allows the actuaries to identify and respond to the unique characteristics of each line of business. Further, since long-term historical data is reviewed, changes in development patterns within a line of business may likewise be identified and considered in the actuaries’ process of selecting ultimate loss.

An actuarial best estimate of ultimate loss is selected for each line of business based on a review of the indications produced by the above methodologies. More consideration is given to those methods that the actuaries deem to be more appropriate in a particular situation. In addition, other metrics such as claim closing ratios, average case reserve levels, paid loss to incurred loss ratios, individual large loss information, and recent insurance pricing changes are reviewed to help the actuaries select the most appropriate estimates of ultimate loss.

The selection of the ultimate loss is based on information unique to each line of business and accident year and the judgment and expertise of the actuaries.

·

Short-Tail versus Long-Tail Lines of Business: The reserving methods described above are generally applied to each line of business, regardless of their classification as short-tail or long-tail. “Tail” refers to the time period between the occurrence of a loss and the final settlement of the claim. The merits of an individual reserving method relative to the line of business and age of accident period are considered in the actuaries’ process of selecting ultimate loss.

Short-tail lines of business, by definition, develop to their ultimate value faster than long-tail lines of business. Property coverages including inland marine along with automobile physical damage coverages are considered short-tail lines of business. Automobile Liability, General Liability, Commercial Multi-Peril Liability and Workers’ Compensation are considered long-tail lines of business. For many liability claims, significant periods of time may elapse between the occurrence of the loss, the reporting of the loss, and the final settlement of the claim. Workers’ Compensation claims can result in providing medical benefits and wage replacement over the course of an injured worker’s lifetime.

In general, more consideration may be given to the results of the development methodologies for short-tail lines than to long-tail lines for accident periods of the same maturity. For example, the indicated ultimate loss using the Incurred Loss Development Method for the most recent accident year is generally considered more reliable for a short-tail line, such as Homeowners Property than a long-tail line, such as Workers’ Compensation.

As mentioned previously, the selection of ultimate loss is based on information unique to each line of business and accident year subject to exceptions, such as the emergence of one or more unusually large claims in a particular accident period for a short-tail line. In this case, the indications produced by the development methods may be overstated (due to development of ultimate losses in excess of policy limits) and such information would be considered in the actuaries’ process of selecting ultimate loss.

·

Immature Accident Periods: The Paid Loss Development Method is generally given less consideration than the Incurred Loss Development Method for less mature accident periods since the relatively low magnitude of losses paid at early evaluations tends to result in less reliable indications from the Paid Loss Development Method. For long-tail lines of business, neither the Incurred nor the Paid Loss Development methods may receive much consideration for the most recent accident period. This is due to the fact that the relatively low magnitude of losses either incurred or paid at early evaluations tends to result in less reliable indications from these methods.

In faster developing, short-tailed lines such as Auto Physical Damage, Special Property, Homeowners, Commercial Multi-Peril Property and Property Damage, the Paid Loss Development Method, the Incurred Loss Development Method and the Bornhuetter-Ferguson methods are primarily used as they typically produce tightly clustered projections for all accident years.



27



The estimation of loss reserves for long-tail lines such as Commercial Auto Liability, Commercial Multi-Peril Liability, and Workers’ Compensation is more complex and is subject to a higher degree of variability than for short-tail lines of business.

The following table presents the liability for unpaid losses and loss settlement expenses by major line of business:

 

 

December 31,

2007

 

December 31,

2006

 

 

 

(in thousands)

Commercial: 

 

 

 

 

 

 

 

Automobile

 

$

308,564

 

$

308,961

 

Workers compensation

 

 

337,286

 

 

327,630

 

Commercial multi-peril

 

 

524,274

 

 

481,173

 

Other commercial

 

 

100,664

 

 

92,542

 

Total commercial

 

 

1,270,788

 

 

1,210,306

 

Personal:

 

 

 

 

 

 

 

Automobile

 

 

81,222

 

 

87,508

 

Homeowners

 

 

27,925

 

 

30,319

 

Other personal

 

 

1,877

 

 

1,716

 

Total personal

 

 

111,024

 

 

119,543

 

Total personal and commercial

 

 

1,381,812

 

 

1,329,849

 

Plus reinsurance recoverables

 

 

164,878

 

 

163,796

 

Total liability

 

$

1,546,690

 

$

1,493,645

 


The following table presents the increase (decrease) in the liability for unpaid losses and loss settlement expenses attributable to insured events of prior years for the year ended December 31, 2007 by line of business:

Increase (Decrease) in the Liability for Unpaid Losses and Loss Settlement Expenses

Attributable to Insured Events of Prior Years

For the Year Ended December 31, 2007

 

Total

 

 

Accident Years

 

2006

 

 

2005

 

2004 and

Prior Years

 

 

(in thousands)

Line of Business

 

  

 

 

 

  

 

 

 

  

 

 

  

 

Commercial:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Automobile

$

(10,214

)

 

$

(1,202

)

 

$

(1,633

)

$

(7,379

)

Workers compensation

 

74

 

 

 

(2,912

)

 

 

(2,396

)

 

5,382

 

Commercial multi-peril

 

(2,146

)

 

 

(12,775

)

 

 

(7,160

)

 

17,789

 

Other commercial

 

(276

)

 

 

(2,174

)

 

 

495

 

 

1,403

 

Total commercial

 

(12,562

)

 

 

(19,063

)

 

 

(10,694

)

 

17,195

 

Personal:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Automobile

 

(5,701

)

 

 

(1,210

)

 

 

(802

)

 

(3,689

)

Homeowners

 

(4,139

)

 

 

(837

)

 

 

(1,103

)

 

(2,199

)

Other personal

 

355

 

 

 

242

 

 

 

(15

)

 

128

 

Total personal

 

(9,485

)

 

 

(1,805

)

 

 

(1,920

)

 

(5,760

)

Total net development

$

(22,047

)

 

$

(20,868

)

 

$

(12,614

)

$

11,435

 




28



In 2007, Harleysville Group recognized net favorable development of $22.0 million in the provision for insured events of prior years, primarily due to lower-than-expected claims severity broadly experienced across all casualty lines in accident years 2003 through 2006, partially offset by adverse development in prior accident years.

A reduction in commercial automobile severity was broadly observed during 2007 and led to the recognition of $10.2 million of favorable development in this line in 2007.

A reduction in workers compensation severity in the aggregate in accident years 2004 through 2006 was observed during 2007 and led to the recognition of favorable development for those accident years in 2007. An increase in workers compensation medical severity in accident years 2003 and prior was observed during 2007 and led to the recognition of adverse development for those accident years in 2007. In total, $0.1 million in adverse development was recognized in the workers compensation line during 2007.

A reduction in commercial multi-peril severity in accident years 2005 and 2006 was observed during 2007 and contributed to the recognition of favorable development for those accident years in 2007. An increase in commercial multi-peril severity in the liability portion of the line in accident years prior to 2005 was observed during 2007 and contributed to the recognition of adverse development for those accident years in 2007. In total, $2.1 million in favorable development was recognized in the commercial multi-peril line during 2007.

A reduction in personal automobile severity was broadly observed during 2007 and led to the recognition of $5.7 million of favorable development in this line in 2007.

A reduction in homeowners severity was broadly observed during 2007 and led to the recognition of favorable development of $4.1 million in this line in 2007.

The tables below break out the change in the estimate of ultimate losses between December 31, 2006 and December 31, 2007 for the 2006, 2005, 2004 and 2003 accident years into severity and frequency components for the major commercial and personal lines of business. Table 1 summarizes the Company’s percentage change in the estimate of ultimate loss and loss settlement expense by line of business between December 31, 2006 and December 31, 2007. Tables 2 and 3 summarize the Company’s percentage change in the estimate of ultimate severity and ultimate claim counts, respectively. The relationship between the three tables is as follows: (1+ the % change in estimated ultimate loss) = (1+ the % change in estimated ultimate severity) x (1+ the % change in estimated ultimate claim counts). The estimated ultimate severity is calculated as the ratio of estimated ultimate loss to estimated ultimate claim counts. The amounts underlying these tables are based on direct loss and claim experience minus ceded loss experience and exclude a small portion of losses associated with business assumed from involuntary pools.

Table 1

 

 

 

Increase (Decrease) in Ultimate Loss and Loss Settlement Expense

 

Between the Years Ended December 31, 2006 and December 31, 2007

 

 

 

 

 

 

 

Accident Years

 

2006

   

2005

   

2004

   

2003

 

 

 

Line of Business

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial:

 

 

 

 

 

 

 

 

 

 

  

 

 

 

Automobile

 

-0.7

%

 

 

-1.1

%

 

 

-0.7

%

 

-2.6

%

Workers compensation

 

-1.5

%

 

 

-1.2

%

 

 

-0.2

%

 

1.7

%

Commercial multi-peril

 

-5.5

%

 

 

-3.9

%

 

 

1.0

%

 

-0.1

%

Other commercial

 

-6.3

%

 

 

1.8

%

 

 

-4.1

%

 

5.3

%

Total commercial

 

-3.4

%

 

 

-2.1

%

 

 

-0.2

%

 

-0.1

%

Personal:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Automobile

 

0.7

%

 

 

-1.1

%

 

 

-1.6

%

 

-1.6

%

Homeowners

 

1.7

%

 

 

-2.5

%

 

 

-1.6

%

 

-1.0

%

Other personal

 

2.5

%

 

 

-1.2

%

 

 

0.2

%

 

-0.1

%

Total personal

 

1.1

%

 

 

-1.6

%

 

 

-1.6

%

 

-1.4

%

Total All Lines

 

-2.6

%

 

 

-2.0

%

 

 

-0.5

%

 

-0.4

%



29




Table 2

 

 

 

Increase (Decrease) in Ultimate Severity

 

Between the Years Ended December 31, 2006 and December 31, 2007

 

 

 

 

 

 

 

Accident Years

 

2006

   

2005

   

2004

   

2003

 

 

 

Line of Business

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial:

 

 

 

 

 

 

 

 

 

 

  

 

 

 

Automobile

 

0.8

%

 

 

-0.9

%

 

 

-0.8

%

 

-2.5

%

Workers compensation

 

-3.1

%

 

 

-0.4

%

 

 

0.2

%

 

2.0

%

Commercial multi-peril

 

-1.4

%

 

 

-1.2

%

 

 

4.5

%

 

1.4

%

Other commercial

 

-8.0

%

 

 

5.1

%

 

 

-3.0

%

 

6.3

%

Total commercial

 

-1.8

%

 

 

-1.0

%

 

 

0.7

%

 

0.4

%

Personal:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Automobile

 

1.4

%

 

 

-0.9

%

 

 

-1.4

%

 

-1.6

%

Homeowners

 

0.3

%

 

 

-2.7

%

 

 

-1.7

%

 

-1.0

%

Other personal

 

-1.5

%

 

 

-1.3

%

 

 

0.1

%

 

-0.1

%

Total personal

 

1.1

%

 

 

-1.5

%

 

 

-1.4

%

 

-1.3

%

Total All Lines

 

-1.6

%

 

 

-1.3

%

 

 

0.1

%

 

-0.1

%


Table 3

 

 

 

Increase (Decrease) in Ultimate Claim Counts

 

Between the Years Ended December 31, 2006 and December 31, 2007

 

 

 

 

 

 

 

Accident Years

 

2006

   

2005

   

2004

   

2003

 

 

 

Line of Business

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial:

 

 

 

 

 

 

 

 

 

 

  

 

 

 

Automobile

 

-1.5

%

 

 

-0.3

%

 

 

0.1

%

 

-0.1

%

Workers compensation

 

1.7

%

 

 

-0.8

%

 

 

-0.4

%

 

-0.2

%

Commercial multi-peril

 

-4.2

%

 

 

-2.7

%

 

 

-3.4

%

 

-1.5

%

Other commercial

 

1.9

%

 

 

-3.1

%

 

 

-1.1

%

 

-1.0

%

Total commercial

 

-1.6

%

 

 

-1.0

%

 

 

-0.9

%

 

-0.5

%

Personal:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Automobile

 

-0.7

%

 

 

-0.2

%

 

 

-0.2

%

 

-0.1

%

Homeowners

 

1.4

%

 

 

0.2

%

 

 

0.1

%

 

0.0

%

Other personal

 

4.0

%

 

 

0.1

%

 

 

0.1

%

 

0.0

%

Total personal

 

0.0

%

 

 

-0.1

%

 

 

-0.2

%

 

0.0

%

Total All Lines

 

-1.0

%

 

 

-0.7

%

 

 

-0.6

%

 

-0.3

%

These tables illustrate that the changes to the Company’s estimates of ultimate loss for prior accident years between December 31, 2006 and December 31, 2007 are primarily driven by the severity component of loss. One exception to this is accident years 2003 and 2004 for total commercial lines. In this year, favorable prior year development was primarily due to favorable claim count development and partially offset by adverse development in claim severity. In this context, the term “severity” does not refer to an actuarial assumption, rather, it refers to “severity” as a descriptive statistic derived from the ratio of estimated ultimate loss to estimated ultimate claim counts. Broadly speaking, as estimates of the ultimate number of claims were relatively stable for the prior accident periods, the changes in estimates of ultimate loss are characterized as resulting from a reduction in severity.



30



The following table presents workers compensation claim count information for the total pooled business in which Harleysville Group participates and payment amounts which are Harleysville Group’s pooling share of the total pooled amounts:

 

 

For the 
year ended
December 31,
2007

 

For the 
year ended
December 31,
2006

 

 

 

(dollars in thousands)

 

Number of claims pending, beginning of period 

 

 

5,481

 

 

6,020

 

Number of claims reported

 

 

8,531

 

 

8,601

 

Number of claims settled or dismissed

 

 

(8,684

)

 

(9,140

)

Number of claims pending, end of period

 

 

5,328

 

 

5,481

 

Losses paid

 

$

59,322

 

$

55,818

 

Loss settlement expenses paid

 

$

13,091

 

$

12,610

 

Workers compensation losses primarily consist of indemnity and medical costs for injured workers.

Harleysville Group records the actuarial best estimate of the ultimate unpaid losses and loss settlement expenses incurred. The estimate represents the actuarially determined expected amount of future payments on all loss and loss settlement expenses incurred on or before December 31, 2007. Actuarial loss reserving techniques and assumptions, which rely on historical information as adjusted to reflect current conditions, have been consistently applied, after including consideration of recent case reserve activity, during the periods presented. Changes in the estimate of the liability for unpaid losses and loss settlement expenses reflect actual payments and evaluations of new information and data since the last reporting date. These changes correlate with actuarial trends.

The following table presents the liability for unpaid losses and loss settlement expenses by case and incurred but not reported (IBNR) reserves by line of business and a statistically determined range of estimates of the ultimate unpaid losses and loss settlement expenses incurred for each line of business as of December 31, 2007. The range of estimates around the actuarial best estimates is statistically determined in order to provide information regarding the variability of the actuarial best estimates. The statistical analysis is completed only on a basis that is net of reinsurance recoverables, as this appropriately reflects Harleysville Group’s risk profile based on the type and quality of its reinsurance. The range is determined using the Monte Carlo Simulation method. This method uses the Company’s actual historical loss data to estimate the mean and standard deviation of a statistical distribution for future loss development. There have been no adjustments made to the historical data. The Company’s application of the Monte Carlo Simulation assumes that loss development factors are normally distributed with a mean and standard deviation derived from the historical data.

Reserve ranges are determined using both paid and incurred loss development data with a 10,000 trial simulation run against each set of data for each line of business presented in the table below. Each simulation generates a unique set of loss development factors randomly generated from the normal distribution with mean and standard deviation as defined above. Each unique set of loss development factors, when applied to the data, produces a unique reserve estimate. At the completion of the simulation, there are 20,000 unique reserve estimates which can be ordered from lowest to highest creating a range of reserve estimates. The resulting range produced by the simulation is used to create a reasonable representation of a 90% confidence interval using the 5% point as the low end of the range and the 95% point as the high end of the range. The 90% confidence interval represents the range of reserve estimates for which there is approximately a 90% probability that the actual reserve amount (which will not be known for many years) is contained within the defined range.  The total commercial lines range and total personal lines range were developed as separate simulations using the means and standard deviations of the individual lines as inputs. Therefore, the 90% confidence interval for all lines of business is smaller than the straight sum of the individual lines of business 90% intervals.



31



The use of this technique to analyze reserve ranges assumes historical data has validity in predicting future outcomes. This assumption is consistent with a key assumption underlying much of insurance pricing and reserving theory.

Liability for Unpaid Losses and Loss Settlement Expenses (LAE)

at December 31, 2007

 

Case

 

IBNR

 

LAE

Liability

 

IBNR

(Inc. LAE)

 

Total

Liability

 

Statistically Determined

Range of Estimates

 

High

 

 

Low

 

 

(in thousands)

 

Line of Business

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Automobile

$

103,900

 

$

152,404

 

$

52,260

 

$

204,664

 

$

308,564

 

$

331,428

 

$

220,846

 

Workers compensation

 

138,462

 

 

153,815

 

 

45,009

 

 

198,824

 

 

337,286

 

 

374,852

 

 

263,814

 

Commercial multi-peril

 

141,797

 

 

238,681

 

 

143,796

 

 

382,477

 

 

524,274

 

 

582,973

 

 

393,947

 

Other commercial

 

21,614

 

 

53,460

 

 

25,590

 

 

79,050

 

 

100,664

 

 

131,433

 

 

61,506

 

Total commercial

 

405,773

 

 

598,360

 

 

266,655

 

 

865,015

 

 

1,270,788

 

 

1,368,376

 

 

965,184

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Personal:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Automobile

 

38,097

 

 

29,000

 

 

14,125

 

 

43,125

 

 

81,222

 

 

91,471

 

 

67,268

 

Homeowners

 

9,637

 

 

12,717

 

 

5,571

 

 

18,288

 

 

27,925

 

 

31,251

 

 

17,012

 

Other personal

 

649

 

 

978

 

 

250

 

 

1,228

 

 

1,877

 

 

2,495

 

 

1,673

 

Total personal

 

48,383

 

 

42,695

 

 

19,946

 

 

62,641

 

 

111,024

 

 

129,894

 

 

98,046

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total net liability

 

454,156

 

 

641,055

 

 

286,601

 

 

927,656

 

 

1,381,812

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Reinsurance recoverables

 

123,260

 

 

41,296

 

 

322

 

 

41,618

 

 

164,878

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross liability

$

577,416

 

$

682,351

 

$

286,923

 

$

969,274

 

$

1,546,690

 

 

 

 

 

 

 

Reinsurance receivables were $167.7 and $167.2 million at December 31, 2007 and 2006, respectively. Of these amounts, $92.1 million and $93.9 million, respectively or 55% and 56%, respectively, of the receivables were due from governmental bodies, regulatory agencies or quasi governmental pools and reinsurance facilities where, Harleysville Group believes, there is virtually no credit risk. The remainder of the reinsurance recoverables are principally due from reinsurers rated A- or higher by the A.M. Best Company.

Because of the nature of insurance claims, there are uncertainties inherent in the estimates of ultimate losses. Harleysville Group’s reorganization of its claims operation in recent years has resulted in new people and processes involved in settling claims. As a result, more recent statistical data reflects different patterns than in the past and gives rise to uncertainty as to the pattern of future loss settlements. There are uncertainties regarding future loss cost trends particularly related to medical treatments and automobile repair. Court decisions, regulatory changes and economic conditions can affect the ultimate cost of claims that occurred in the past. Accordingly, the ultimate liability for unpaid losses and loss settlement expenses will likely differ from the amount recorded at December 31, 2007.

The property and casualty industry has had substantial aggregate loss experience from claims related to asbestos-related illnesses, environmental remediation, product liability, mold, and other uncertain exposures. Harleysville Group has not experienced significant losses from such claims.

Net catastrophe losses decreased $4.7 million for the year ended December 31, 2007, primarily due to less severe catastrophes impacting Harleysville Group in 2007.

Effective for one year from July 1, 2007, the Company’s subsidiaries and the Mutual Company and its wholly owned subsidiaries renewed its catastrophe reinsurance which provides coverage ranging from 75% to 85% of up to $250.0 million in excess of a retention of $50.0 million for any given catastrophe excluding terrorism for commercial lines. Harleysville Group’s 2007 pooling share of this coverage would range from 75% to 85% of up to $180.0 million in excess of a retention of $36.0 million for any given catastrophe. Pursuant to the terms of the treaty, the maximum recovery would be $195.0 million for any catastrophe involving an insured loss equal to or greater than $300.0 million. Harleysville Group’s 2007 pooling share of this maximum recovery would be $140.4 million for any catastrophe



32



involving an insured loss of $216.0 million or greater. The treaty includes reinstatement provisions providing for coverage for a second catastrophe and requiring payment of an additional premium in the event of a first catastrophe occurring.

The income tax expense for the year ended December 31, 2007 includes the tax benefit of $7.2 million associated with tax-exempt income compared to $8.6 million in the prior year.

Underwriting expenses, including amortization of deferred policy acquisition costs, decreased $7.2 million for the year ended December 31, 2007 compared to the prior year. The decrease in underwriting expenses was primarily due to a decrease in head count resulting from on-going expense reduction initiatives, and lower incentive compensation, pension expense and severance charges.

Harleysville Group froze its defined benefit pension plan at the then current benefit levels as of March 31, 2006. Harleysville Group’s portion of pension expense for the plan was $0.5 million and $1.9 million for 2007 and 2006, respectively. Harleysville Group enhanced its 401(k) retirement savings plan to provide for a company contribution equal to 5% of salary for all eligible employees, effective April 1, 2006, and recognized expense of $3.7 million and $2.9 million in 2007 and 2006, respectively due to this enhancement.

Other income increased $0.2 million for the year ended December 31, 2007 primarily due to a $2.7 million gain realized on the sale of the Company’s office building in Traverse City, Michigan in the second quarter of 2007, partially offset by a decrease of $2.2 million in claim handling fees received in connection with the National Flood Insurance Program, related primarily to flood claims from Hurricane Katrina.

2006 Compared to 2005

Premiums earned decreased $2.7 million for the year ended December 31, 2006. The decrease was primarily due to a decrease in premiums earned for personal lines of $8.8 million, partially offset by an increase of $6.1 million in commercial lines premiums earned. The increase in premiums earned for commercial lines was primarily due to higher average premiums, partially offset by fewer policy counts in the commercial automobile line of business. The decline in premiums earned for personal lines was primarily due to fewer policy counts. The reduction in personal lines volume was driven primarily by a reduction of personal automobile business from the continued implementation of more stringent underwriting processes.

Investment income increased $12.1 million for the year ended December 31, 2006, resulting from an increase in invested assets, a greater percentage of invested assets in fixed maturity securities and higher interest rates on short-term investments.

Realized investment gains increased $40.4 million for the year ended December 31, 2006, primarily resulting from gains on the sale of equity securities in the second quarter of 2006.

Income before income taxes and cumulative effect of accounting change increased $77.4 million for the year ended December 31, 2006 compared to the prior year. The increase was primarily due to the increase in investment income, increased realized investment gains and improved underwriting results.

The improved underwriting results were primarily due to improved underwriting results in both commercial and personal lines.

Harleysville Group’s statutory combined ratio decreased to 98.6% for the year ended December 31, 2006 from 102.2% for the year ended December 31, 2005. Such decrease was due to improved underwriting results in both commercial lines and personal lines, primarily resulting from improved loss experience, partially offset by greater catastrophe losses and higher underwriting expenses in 2006.



33



The statutory combined ratios by line of business for the year ended December 31, 2006 as compared to the year ended December 31, 2005 were as follows:

 

 

For the Year Ended

December 31,

 

 

 

2006

 

2005

 

Commercial: 

 

 

 

 

 

 

 

Automobile

 

 

99.3%

 

 

101.1%

 

Workers compensation

 

 

117.2%

 

 

124.0%

 

Commercial multi-peril

 

 

98.9%

 

 

101.5%

 

Other commercial

 

 

86.6%

 

 

98.7%

 

Total commercial

 

 

100.3%

 

 

104.3%

 

Personal:

 

 

 

 

 

 

 

Automobile

 

 

99.3%

 

 

99.2%

 

Homeowners

 

 

82.6%

 

 

87.6%

 

Other personal

 

 

69.8%

 

 

72.3%

 

Total personal

 

 

90.6%

 

 

93.1%

 

Total personal and commercial

 

 

98.6%

 

 

102.2%

 

The commercial lines statutory combined ratio decreased to 100.3% for the year ended December 31, 2006 from 104.3% for the year ended December 31, 2005. The decrease is primarily due to declines in the combined ratio for all lines of business due to improved loss severity. The personal lines statutory combined ratio decreased to 90.6% for the year ended December 31, 2006 from 93.1% for the year ended December 31, 2005. The decrease is primarily due to improved property results in the homeowners line, partially offset by higher catastrophe losses.

The following table presents the increase (decrease) in the liability for unpaid losses and loss settlement expenses attributable to insured events of prior years for the year ended December 31, 2006 by line of business:

Increase (Decrease) in the Liability for Unpaid Losses and Loss Settlement Expenses

Attributable to Insured Events of Prior Years

For the Year Ended December 31, 2006

 

Total

 

 

Accident Years

 

2005

 

 

2004

 

2003 and

Prior Years

 

 

(in thousands)

Line of Business

 

  

 

 

 

  

 

 

 

  

 

 

  

 

Commercial:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Automobile

$

(5,136

)

 

$

1,134

 

 

$

(5,711

)

$

(559

)

Workers compensation

 

341

 

 

 

(2,931

)

 

 

(3,705

)

 

6,977

 

Commercial multi-peril

 

(3,110

)

 

 

(12,328

)

 

 

(6,108

)

 

15,326

 

Other commercial

 

(191

)

 

 

(1,131

)

 

 

(1,323

)

 

2,263

 

Total commercial

 

(8,096

)

 

 

(15,256

)

 

 

(16,847

)

 

24,007

 

Personal:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Automobile

 

(4,968

)

 

 

(2,402

)

 

 

(3,484

)

 

918

 

Homeowners

 

(5,505

)

 

 

(1,357

)

 

 

(1,968

)

 

(2,180

)

Other personal

 

484

 

 

 

193

 

 

 

83

 

 

208

 

Total personal

 

(9,989

)

 

 

(3,566

)

 

 

(5,369

)

 

(1,054

)

Total net development

$

(18,085

)

 

$

(18,822

)

 

$

(22,216

)

$

22,953

 

In 2006, Harleysville Group recognized net favorable development of $18.1 million in the provision for insured events of prior years, primarily due to lower-than-expected claims severity in casualty lines in accident years 2002 through 2005, partially offset by adverse development in prior accident years.

A reduction in commercial automobile severity in accident years 2002 through 2004 was observed during 2006 and led to the recognition of favorable development for those accident years in 2006. An increase in commercial



34



automobile severity in accident year 2005 and in accident years prior to 2002 was observed during 2006 and led to the recognition of adverse development for those accident years in 2006. In total, $5.1 million in favorable development was recognized in the commercial automobile line during 2006.

A reduction in workers compensation severity in accident years 2002 through 2005 was observed during 2006 and led to the recognition of favorable development for those accident years in 2006. An increase in workers compensation medical severity in accident years 1997 through 2001 was observed during 2006 and led to the recognition of adverse development for those accident years in 2006. In total, $0.3 million in adverse development was recognized in the workers compensation line during 2006.

A reduction in commercial multi-peril severity in accident years 2002 through 2005 was observed during 2006 and led to the recognition of favorable development for those accident years in 2006. An increase in commercial multi-peril severity in the liability portion of the line in accident years prior to 2002 was observed during 2006 and led to the recognition of adverse development for those accident years in 2006. In total, $3.1 million in favorable development was recognized in the commercial multi-peril line during 2006.

A reduction in personal automobile severity for accident years 2002 through 2005 was observed during 2006 and led to the recognition of favorable development for those accident years in 2006. An increase in personal automobile severity for 1997 and prior accident years was observed during 2006 and led to the recognition of adverse development for those accident years in 2006. In total, $5.0 million of favorable development was recognized in the personal automobile line during 2006.

A reduction in homeowners severity was broadly observed during 2006 and led to the recognition of favorable development of $5.5 million in this line in 2006.

Net catastrophe losses increased $7.4 million for the year ended December 31, 2006, primarily due to more severe catastrophes impacting Harleysville Group in 2006.

Underwriting expenses, including amortization of deferred policy acquisition costs, increased $1.0 million for the year ended December 31, 2006 compared to the prior year. The increase in underwriting expenses was primarily due to higher incentive costs for agents and employees, and higher compensation expenses recognized under SFAS No. 123(R), which was adopted as of January 1, 2006, partially offset by lower pension costs and lower severance charges. Severance charges of $1.2 million and $3.5 million were incurred in 2006 and 2005, respectively, related to ongoing expense-reduction initiatives.

Harleysville Group froze its defined benefit pension plan at the then current benefit levels as of March 31, 2006. Harleysville Group’s portion of pension expense for the plan was $1.9 million and $9.7 million for 2006 and 2005, respectively. Harleysville Group enhanced its 401(k) retirement savings plan to provide for a company contribution equal to 5% of salary for all eligible employees, effective April 1, 2006, and recognized expense of $2.9 million in 2006 due to this enhancement.

Other income increased $1.2 million for the year ended December 31, 2006 primarily due to an increase of $1.7 million in claim handling fees received in connection with the National Flood Insurance Program, related primarily to flood claims from Hurricane Katrina.

New Accounting Standards

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” This statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. This statement applies under other accounting pronouncements that require or permit fair value measurements. The statement is effective for financial statements issued for fiscal years beginning after November 15, 2007. The impact of adopting this statement on Harleysville Group’s results of operations and financial condition is not expected to be material.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities--Including an amendment of FASB Statement No. 115.” SFAS No. 159 permits companies to choose to measure many financial instruments and certain other items at fair value at specified election dates. Upon adoption, an entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. Most of the provisions apply only to entities that elect the fair value option. However, the amendment to SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” applies to all



35



entities with available for sale and trading securities. SFAS No. 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. The impact of adopting this statement on Harleysville Group’s results of operations and financial condition is not expected to be material.

Liquidity and Capital Resources

Liquidity is a measure of the ability to generate sufficient cash to meet cash obligations as they come due. Harleysville Group’s primary sources of cash are premium income, investment income and maturing investments. Cash outflows can be variable because of uncertainties regarding settlement dates for liabilities for unpaid losses and because of the potential for large losses, either individually or in the aggregate. Accordingly, Harleysville Group maintains investment and reinsurance programs generally intended to provide adequate funds to pay claims without forced sales of investments. Harleysville Group models its exposure to catastrophes and has the ability to pay claims without selling held to maturity securities even for events having a low (less than 1%) probability. Even in years of greater catastrophe frequency, Harleysville Group has been able to pay claims without liquidating any investments. Harleysville Group has also considered scenarios of declines in revenue and increases in loss payments, and has the ability to meet cash requirements under such scenarios without selling held to maturity securities. Harleysville Group’s policy with respect to fixed maturity investments is to purchase only those that are of investment grade quality.

Net cash provided by operating activities was $171.5 million and $166.1 million for 2007 and 2006, respectively. The increase in net cash provided by operating activities during 2007 is primarily from greater investment income and lower federal income tax payments, partially offset by a decrease in net cash provided by underwriting activities.

Net cash used by investing activities was $92.7 million and $168.8 million for 2007 and 2006, respectively. The change is primarily due to lower net purchases of investments due to the increase in cash used by financing activities.

Financing activities used net cash of $78.7 million and provided net cash of $2.5 million for 2007 and 2006, respectively. The change is primarily due to the purchase of treasury stock in 2007, a decrease in the issuance of common stock and an increase in dividends paid.

Harleysville Group’s investment strategy is designed to complement and support the insurance operations. Harleysville Group considers projected cash flow (premiums, investment income, reinsurance programs, liability payout patterns, general expenses, large seasonal obligations, intercompany transfers, etc.) to assure that sufficient liquidity exists within Harleysville Group and the Mutual Company. Maintaining a regular maturity schedule in readily marketable securities is an essential part of addressing liquidity. This regular maturity schedule is maintained in all interest rate environments. After-tax yield will be maximized consistent with safety and liquidity considerations by investment in taxable or tax-exempt securities, depending on Harleysville Group’s tax position.

Harleysville Group participates in a securities lending program whereby certain fixed maturity securities from the investment portfolio are loaned to other institutions for a short period of time in return for a fee. At December 31, 2007, Harleysville Group had received, and had the obligation to return, cash collateral of $123.5 million. The cash collateral received was invested, as described below, in investments with a fair value at December 31, 2007 of $122.1 million, related to securities on loan with a fair value of $120.6 million. Harleysville Group’s policy is to require initial collateral of 102% of the fair value of loaned securities plus accrued interest, which is required to be maintained daily by the borrower at no less than 100% of such fair value plus accrued interest over the life of the loan. Cash collateral received can be further invested in money market instruments, government securities, “A” rated corporate obligations, “AAA” rated asset-backed securities or GICs and Funding Agreements from issuers rated “A” or better. The cash collateral Harleysville Group received was invested as follows at December 31, 2007: 52% of the collateral was held in cash and cash equivalents (maturities of three months or less) and 48% of the collateral was held in securities which may fluctuate in value and have variable interest rates and maturities of up to three years. These securities are classified as available for sale. The securities on loan to others have been segregated from the other invested assets on the balance sheet. In addition, the assets and liabilities have been grossed up to reflect the investment of the collateral received under the securities lending program and the obligation to return this collateral upon the return of the loaned securities.

 



36



At December 31, 2007, Harleysville Group held the following fixed maturity investments in its securities lending collateral portfolio:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stated

Maturity

Date

 

 

Cost

 

 

Fair Value

 

 

Unrealized

Gain(Loss)

 

 

 

(in thousands)

 

Structured Investment Vehicles (SIVs)

 

 

 

 

 

 

 

 

 

 

 

 

Cheyne Finance LLC, Medium Term Note SER 144A

 

02/10/2009

 

$

6,898

 

$

6,898

 

 

¾

 

Stanfield Victoria LLC, Medium Term Note SER 144A

 

08/25/2008

 

 

2,673

 

 

2,604

 

$

(69

)

Stanfield Victoria LLC, Medium Term Note SER 144A

 

08/05/2008

 

 

2,673

 

 

2,604

 

 

(69

)

Liberty Lighthouse, Medium Term Note SER 144A

 

03/16/2010

 

 

2,577

 

 

2,527

 

 

(50

)

Sigma Finance Inc, Medium Term Note

 

01/16/2009

 

 

7,731

 

 

7,570

 

 

(161

)

Liquid Funding LTD, Medium Term Note SER 144A

 

11/04/2008

 

 

5,151

 

 

5,162

 

 

11

 

Liquid Funding LTD, Medium Term Note SER 144A

 

09/29/2008

 

 

2,674

 

 

2,662

 

 

(12

)

Atlas Capital Fund. Corp, Medium Term Note SER 144A

 

07/11/2008

 

 

2,674

 

 

2,669

 

 

(5

)

Total SIVs

 

 

 

$

33,051

 

$

32,696

 

$

(355

)

 

 

 

 

 

 

 

 

 

 

 

 

 

Other Investments

 

 

 

 

 

 

 

 

 

 

 

 

CIT Group Inc., Medium Term Note SER A

 

05/14/2009

 

$

2,577

 

$

2,568

 

$

(9

)

CIT Group Inc., Medium Term Note

 

11/04/2008

 

 

2,578

 

 

2,560

 

 

(18

)

Hertz Vehicle Financing LLC ABS

 

12/09/2008

 

 

2,578

 

 

2,567

 

 

(11

)

Monumental Global Funding III, Medium Term Note

 

05/24/2010

 

 

2,578

 

 

2,571

 

 

(7

)

Monumental Global Funding II, Medium Term Note

 

09/22/2009

 

 

2,577

 

 

2,559

 

 

(18

)

Pacific Life Global Funding Note SER 144A

 

08/10/2009

 

 

2,578

 

 

2,574

 

 

(4

)

SLM Corp. Medium Term Note SER 144A

 

03/16/2009

 

 

8,248

 

 

8,012

 

 

(236

)

General Electric Cap Corp Medium Term Note SER A

 

05/19/2008

 

 

2,674

 

 

2,672

 

 

(2

)

Barclays Bank PLC Corp. CD

 

02/21/2008

 

 

2,674

 

 

2,674

 

 

¾

 

Citibank NA Corp. CD

 

02/21/2008

 

 

2,674

 

 

2,674

 

 

¾

 

Wachovia Corp. CD

 

02/21/2008

 

 

2,674

 

 

2,674

 

 

¾

 

Open End Repo Agreements

 

 

 

 

55,252

 

 

55,252

 

 

¾

 

Total Other Investments

 

 

 

$

89,662

 

$

89,357

 

$

(305

)

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Securities Lending Portfolio

 

 

 

$

122,713

 

$

122,053

 

$

(660

)

 

 

 

 

 

 

 

 

 

 

 

 

 

The fixed maturity investments in the SIVs consist predominantly of asset-backed and mortgaged-backed securities. Each of the SIVs listed above represents a senior claim on the assets of the issuer. The Cheyne and Stanfield Victoria holdings are in technical default and are currently under the supervision of receivers appointed to protect the interests of senior creditors. In the fourth quarter of 2007, an impairment loss of $0.8 million was recognized on the Cheyne holding due to a significant deterioration in the credit worthiness of the issuer.

Due to illiquid market conditions and deteriorating fundamentals in the housing industry, the value of some of the underlying assets that secure our position as a senior creditor in the SIVs is uncertain at this time. Depending upon developments involving the performance of the assets held by the SIVs, it is possible that the SIV holdings listed above may be written down in the income statement in the future.

Subsequent to December 31, 2007, the Atlas Capital Funding Corp. Medium Term Note was converted into a Wachovia Bank Certificate of Deposit with the same maturity date. In February 2008, we divested both of our Liquid Funding LTD Medium Term Notes maturing on November 4, 2008 and September 29, 2008 for losses of $15,000 and $10,000, respectively.

One of the holdings within the security lending portfolio, with an unrealized loss of $18,000 at December 31, 2007, has had an unrealized loss for over twelve months.



37



The Company had $4.0 million of cash and marketable securities at December 31, 2007, which are available for general corporate purposes including dividends, debt service, capital contributions to subsidiaries, acquisitions and the repurchase of stock. In June 2007, the Company’s Board of Directors authorized a stock repurchase plan under which up to 1.6 million shares of its outstanding common stock could be repurchased through an open market purchase program. The Company was authorized to repurchase shares from the Mutual Company, which owns 53% of the Company’s stock, at fair market value terms on the date of purchase and from the public float to amounts that are proportional to the respective ownership percentages of the Mutual Company and the public float as of the authorization date. This program was completed on July 18, 2007. On August 1, 2007, the Board of Directors authorized the Company to repurchase an additional 1.6 million shares of its outstanding common stock for a two year period under terms similar to the first repurchase authorization. As of December 31, 2007, the Company had repurchased 335,439 shares under the second authorization, leaving 1,264,561 shares authorized to be repurchased. An additional 346,807 shares were repurchased through March 5, 2008. Harleysville Group has no other material commitments for capital expenditures as of December 31, 2007.

As a holding company, the Company’s principal source of cash for the payment of dividends is dividends from its insurance subsidiaries. The Company’s insurance subsidiaries are subject to state laws that restrict their ability to pay dividends. The Company’s insurance subsidiaries declared dividends payable to the Company of $117.6 million in June 2007. As of December 31, 2007 dividends of $63.0 million had been paid to the Company.

Applying the current regulatory restrictions as of December 31, 2007, $112.2 million would be available for distribution to the Company by its subsidiaries after June 5, 2008 without prior regulatory approval. See the Business-Regulation section of this Form 10-K, which includes a reconciliation of net income and shareholders’ equity as determined under statutory accounting practices to net income and shareholders’ equity as determined in accordance with accounting principles generally accepted in the United States of America. Also, see Note 8 of the Notes to Consolidated Financial Statements.

On August 18, 2006, Harleysville Group Inc. entered into a credit agreement with HSBC Bank USA, National Association, as Administrative Agent, and participating lenders relating to a five year $100 million revolving credit facility. At Harleysville Group Inc.’s election, interest will be calculated at the LIBOR Rate plus a Margin (currently 0.750% based on the credit rating of the Company’s debt) or the Alternate Base Rate (the greater of the Prime Rate or the Federal Funds Effective Rate plus 1/2 of 1%). In addition, there is a fee of 0.150% per annum on the loan commitment amount, regardless of usage. The agreement requires compliance with certain covenants, which include minimum net worth and leverage and fixed charge coverage ratios. The credit facility was available for general corporate purposes. There have been no borrowings under the credit facility. The Company was in compliance with all applicable covenants. Effective January 8, 2008, the Company terminated this credit agreement because the Company felt it was no longer needed.

The National Association of Insurance Commissioners (NAIC) adopted risk-based capital (RBC) standards that require insurance companies to calculate and report statutory capital and surplus needs based on a formula measuring underwriting, investment and other business risks inherent in an individual company’s operations. These RBC standards have not affected the operations of Harleysville Group since each of the Company’s insurance subsidiaries has statutory capital and surplus in excess of RBC requirements.

These RBC standards require the calculation of a ratio of total adjusted capital to Authorized Control Level. Insurers with a ratio below 200% are subject to different levels of regulatory intervention and action. Based upon their 2007 statutory financial statements, the ratio of total adjusted capital to the Authorized Control Level for the Company’s eight insurance subsidiaries at December 31, 2007 ranged from 543% to 677%.



38



The following summarizes Harleysville Group’s contractual obligations at December 31, 2007.

 

 

Total

 

Less Than
1 Year

 

1-3 Years

 

4-5 Years

 

After
5 Years

 

 

 

 (in thousands)

 

Contractual obligations:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Debt

 

$

118,500

 

 

 

 

 

 

 

$

18,500

 

$

100,000

 

Interest on debt

 

$

36,763

 

$

6,800

 

$

13,600

 

$

12,769

 

$

3,594

 

Gross liability for unpaid losses and
loss settlement expenses

 

$

1,546,690

 

$

371,300

 

$

433,043

 

$

201,052

 

$

541,295

 

Total

 

$

1,701,953

 

$

378,100

 

$

446,643

 

$

232,321

 

$

644,889

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The table above does not include capital lease obligations, operating lease obligations or purchase obligations as they are either not applicable or not material. The timing of the amounts for the gross liability for unpaid losses and loss settlement expenses is an estimate based on historical experience and expectations of future payment patterns. However, the timing of these payments may vary significantly from the amounts stated above.

Property and casualty insurance premiums are established before the amount of losses and loss settlement expenses, or the extent to which inflation may affect such expenses, are known. Consequently, Harleysville Group attempts, in establishing rates, to anticipate the potential impact of inflation. In the past, inflation has contributed to increased losses and loss settlement expenses.

Risk Factors

You should consider carefully the following risks, as well as the other information contained in this 2007 Report on Form 10-K. If any of the following events described in the risk factors below actually occur, our business, financial condition and results of operations could be adversely affected. You should refer to the other information set forth in this 2007 Report on Form 10-K including our consolidated financial statements and the related notes.

Risks Related to the Property and Casualty Insurance Industry Generally

If our estimated liability for losses and loss settlement expenses is incorrect, our reserves may not be adequate to cover our ultimate liability for losses and loss settlement expenses and may have to be increased.

We are required to maintain loss reserves for our estimated liability for losses and loss settlement expenses associated with reported and unreported claims for each accounting period. We regularly review our reserving techniques and our overall amount of reserves and, based on our estimated liability, raise or lower the levels of our reserves accordingly. If our estimates are incorrect and our reserves are inadequate, we are obligated to increase our reserves. An increase in reserves results in an increase in losses and a reduction in our net income for the period in which the deficiency in reserves is identified. Accordingly, an increase in reserves could have a material adverse effect on our results of operations, liquidity and financial condition. Our reserve amounts are estimated based on what we expect our ultimate liability for losses and loss settlement expenses to be. These estimates are based on facts and circumstances of which we are aware, predictions of future events, trends in claims severity and frequency and other subjective factors. Although we use a number of actuarial methods to project our ultimate liability, there is no method that can always exactly predict our ultimate liability for losses and loss settlement expenses.

In addition to reviewing our reserving techniques, as part of our reserving process we also consider:

·

information regarding each claim for losses;

·

our loss history and the industry’s loss history;

·

legislative enactments, judicial decisions and legal developments regarding damages;

·

changes in political attitudes; and

·

trends in general economic conditions, including inflation.



39



If certain catastrophic events occur, they could have a significant impact on our operational results and financial condition.

Results of property insurers are subject to weather and other events prevailing in any given year. While one year may be relatively free of major weather or other disasters, another year may have numerous such events causing results for that year to be materially worse than for other years.

Our insurance subsidiaries have experienced, and are expected in the future to experience, catastrophe losses. It is possible that a catastrophic event or a series of multiple catastrophic events could have a material adverse effect on the operating results and financial condition of our insurance subsidiaries, thereby limiting the ability of our insurance subsidiaries to pay dividends to us. In the last 9 years, the largest non-flood catastrophe to affect our results of operations was Hurricane Floyd in the third quarter of 1999, which resulted in $15.1 million of losses.

Various events can cause catastrophes, including severe winter weather, hurricanes, windstorms, earthquakes, hail, war, terrorism, explosions and fires. The frequency and severity of these catastrophes are inherently unpredictable. The extent of losses from a catastrophe is a function of both the total amount of insured exposures in the area affected by the event and the severity of the event.

Our insurance subsidiaries seek to reduce the impact on our business of a catastrophe through geographic diversification and through the purchase of reinsurance covering various categories of catastrophes, which generally excludes terrorism. Nevertheless, reinsurance may prove inadequate if

·

a major catastrophic loss exceeds the reinsurance limit or

·

an insurance subsidiary pays a number of smaller catastrophic loss claims that, individually, fall below the subsidiary’s retention level.

We are heavily regulated in the states in which we operate and if we violate those regulations or if the regulations unreasonably restrict our ability to do business, or if they change significantly, it could have an adverse effect on our business.

We are subject to extensive supervision and regulation in the states in which we transact business. The purpose of supervision and regulation is to protect individual policyholders and not shareholders or other investors. Our business can be adversely affected by private passenger automobile insurance regulations and any other regulations affecting property and casualty insurance companies. For example, laws and regulations can reduce or set rates at levels that we do not believe are adequate for the risks we insure. Other laws and regulations can limit our ability to cancel or refuse to renew policies and require us to offer coverage to all consumers. Changes in laws and regulations, or their interpretations, pertaining to insurance, including workers compensation, may also have an adverse effect on our business. Although the federal government does not directly regulate the insurance industry, federal initiatives, such as federal terrorism backstop legislation, from time to time, also can impact the insurance industry.

In addition, proposals intended to control the cost and availability of health care services have been debated in the U.S. Congress and state legislatures. Although we do not write health insurance, rules affecting health care services can affect other insurance that we write, including workers compensation and commercial and personal automobile and liability insurance. We cannot determine whether or in what form health care reform legislation may be adopted by the U.S. Congress or any state legislature. We also cannot determine the nature and effect, if any, that the adoption of health care legislation or regulations, or changing interpretations, at the federal or state level would have on us.

If demand for property and casualty insurance decreases, it could have an adverse impact on our business.

Historically, the results of the property and casualty insurance industry have been subject to significant fluctuations over time due to competition and due to unpredictable developments, including:

·

natural and man-made disasters;

·

fluctuations in interest rates and other changes in the investment environment that affect returns on our investments;

·

inflationary pressures that affect the size of losses; and

·

legislative and regulatory changes and judicial decisions that affect insurers’ liabilities.



40



The demand for property and casualty insurance, particularly commercial lines, also can vary with the overall level of economic activity.

If we are unable to reduce our exposure to risks through reliable reinsurance or if the cost of reinsurance increases, our risk of loss, or the cost of controlling our risk of loss, will increase.

We transfer a portion of our exposure to selected risks to other insurance and reinsurance companies through reinsurance arrangements. Under our reinsurance arrangements, another insurer assumes a specified portion of our losses and loss adjustment expenses in exchange for a specified portion of policy premiums. The availability, amount and cost of reinsurance depend on market conditions and may vary significantly. Any decrease in the amount of our reinsurance will increase our risk of loss. Furthermore, we face a credit risk when we obtain reinsurance because we are still liable for the transferred risks if the reinsurer cannot meet the transferred obligations. Therefore, the inability of any of our reinsurers to meet its financial obligations could materially and adversely affect our operations.

The threat of terrorism and military and other actions may result in decreases in our net income, revenue and assets under management and may adversely affect our investment portfolio.

The threat of terrorism, both within the United States and abroad, and military and other actions and heightened security measures in response to these types of threats, may cause significant volatility and declines in the equity markets in the United States, Europe and elsewhere, as well as loss of life, property damage, additional disruptions to commerce and reduced economic activity. Actual terrorist attacks could cause losses from insurance claims related to the property and casualty insurance operations of Harleysville Group, as well as a decrease in our stockholders’ equity, net income and/or revenue. The effects of changes related to Harleysville Group may result in a decrease in our stock price. The Terrorism Risk Insurance Act of 2002, which was originally extended in 2005 and extended again in 2007, requires that some coverage for terrorist loss be offered by primary property insurers and provides Federal assistance for recovery of claims through 2014. In addition, some of the assets in our investment portfolio may be adversely affected by declines in the equity markets and economic activity caused by the continued threat of terrorism, ongoing military and other actions and heightened security measures.

We cannot predict at this time whether and the extent to which industry sectors in which we maintain investments may suffer losses as a result of potential decreased commercial and economic activity, or how any such decrease might impact the ability of companies within the affected industry sectors to pay interest or principal on their securities, or how the value of any underlying collateral might be affected.

We can offer no assurances that the threats of future terrorist-like events in the United States and abroad or military actions by the United States will not have a material adverse effect on our business, financial condition or results of operations.

Certain changes in the accounting standards issued by the Financial Accounting Standards Board or other standard-setting bodies could have a material adverse impact on our reported net income.

We are subject to the application of U.S. GAAP and other accounting standards, which are periodically revised and/or expanded. As such, we are required to adopt new or revised accounting standards issued by recognized authoritative bodies, including the Financial Accounting Standards Board. It is possible that future changes required to be adopted could change the current accounting treatment that we apply and such changes could result in material adverse impacts on our results of operations and financial condition.

If our investments, including our securities lending collateral, lose value, our revenues, earnings and financial position will be adversely affected.

Like many other property and casualty insurance companies, we depend on income from our investment portfolio for a significant portion of our revenues and earnings. Any significant decline in our investment income as a result of falling interest rates, decreased dividend payment rates or general market conditions would have an adverse effect on our results. Any significant decline in the market value of our investments, including the investments in our securities lending collateral portfolio, would reduce our shareholders’ equity and our policyholders’ surplus, which could impact our ability to write additional business.



41



If our financial strength ratings are reduced, we may be adversely impacted.

Insurance companies are subject to financial strength ratings produced by external rating agencies. Higher ratings generally indicate greater financial stability and a stronger ability to pay claims. Ratings are assigned by rating agencies to insurers based upon factors that they believe are relevant to policyholders. Ratings are not recommendations to buy, hold or sell our securities.

Although other agencies cover the property and casualty industry, we believe our ability to write business is most influenced by our rating from A. M. Best. According to A. M. Best, its ratings are designed to assess an insurer’s financial strength and ability to meet ongoing policyholder obligations. Currently, our rating from A. M. Best is “A-”, the 4th of A. M. Best’s 16 ratings. A rating below “A-” from A. M. Best could materially adversely affect the business we write. We believe that our financial strength rating from Moody’s (which is A3, the 7th of Moody’s 21 ratings), although important, has less of an impact on our business. An unfavorable change in our Moody’s financial strength rating, however, could make it more expensive for us to access capital markets. We cannot be sure that we will maintain our current A. M. Best or Moody’s ratings. Although Standard & Poor’s rates our debt securities at BBB-/Stable (the 10th of Standard & Poor’s 23 ratings), Standard & Poor’s does not currently rate our financial strength and ability to meet ongoing obligations.

Risks Related to Our Company in Particular

We face significant competition from other regional and national insurance companies, agents and from self-insurance, which may result in lower revenues.

We compete with local, regional and national insurance companies, including direct writers of insurance coverage. Many of these competitors are larger than we are and many have greater financial, technical and operating resources. In addition, we face competition within each insurance agency that sells our insurance because we sell through independent agencies that represent more than one insurance company.

The property and casualty insurance industry is highly competitive on the basis of product, price and service. If our competitors offer products with more coverage, or price their products more aggressively, our ability to grow or renew our business may be adversely impacted. There are more than 250 groups writing property and casualty insurance in the United States, and we are approximately 60th in size. Our most significant competitors vary significantly in our different lines of business and in the geographic markets in which we compete. The internet also could emerge as a significant source of new competition, both from existing competitors using their brand name and resources to write business through this distribution channel and from new competitors.

We also face competition because of entities that self-insure, primarily in the commercial insurance market. From time to time, certain of our customers and potential customers may examine the benefits and risks of self-insurance and other alternatives to traditional insurance.

A number of new, proposed or potential legislative or industry developments could further increase competition in the property and casualty insurance industry. These developments include:

·

the enactment of the Gramm-Leach-Bliley Act of 1999, which could result in increased competition from new entrants to the insurance market, including banks and other financial service companies;

·

programs in which state-sponsored entities provide property insurance in catastrophe-prone areas or other alternative market types of coverage; and

·

changing practices caused by the internet, which have led to greater competition in the insurance business and, in some cases, greater expectations for customer service.

New competition from these developments could cause the supply or demand for insurance to change, which could adversely affect our results of operations and financial condition.



42



If adverse conditions in the eastern and midwestern United States exist, our business would be disproportionately impacted.

We write property and casualty insurance business in the eastern and midwestern United States. Consequently, unusually severe storms or other natural or man-made disasters that destroy property in these states could adversely affect our operations. Our revenues and profitability also are subject to prevailing economic and regulatory conditions in the states in which we write insurance. We may be exposed to risks of adverse developments that are greater than if we conducted business nationwide.

We depend on independent insurance agents, which exposes us to risks not applicable to companies with dedicated agents.

We market and sell our insurance products through independent, non-exclusive insurance agencies. These agencies are not obligated to sell our insurance products, and generally they also sell our competitors’ insurance products. As a result, our business depends in part on the marketing and sales efforts of these agencies. If we diversify and expand our business geographically, then we may need to expand our network of agencies to successfully market our products. If these agencies fail to market our products successfully, our business may be adversely impacted. Also, independent agents may decide to sell their businesses to banks, other insurance agencies or other businesses. Changes in ownership of agencies, or expansion of agencies through acquisition, could adversely affect an agency’s ability to control growth and profitability, thereby adversely affecting our business.

If our insurance subsidiaries are not able to pay adequate dividends to us, our ability to meet our obligations and pay dividends would be affected.

Our principal assets are the shares of capital stock of our insurance company subsidiaries. We principally rely on dividends from our insurance company subsidiaries to meet our obligations for paying principal and interest on outstanding debt obligations and for paying corporate expenses and dividends to shareholders. As described below, the payment of dividends by our insurance company subsidiaries is subject to regulatory restrictions and will depend on the surplus and future earnings of these subsidiaries, as well as other regulatory restrictions. As a result, we may not be able to receive dividends from these subsidiaries at times and in amounts necessary to meet our obligations or to allow us to pay dividends.

Generally, the maximum dividend that may be paid by an insurance subsidiary during any year without prior regulatory approval is limited to a stated percentage of that subsidiary’s statutory surplus as of a certain date, or adjusted net income of the subsidiary for the preceding year. Our insurance subsidiaries paid dividends to us of $63.0 million in 2007 and $15.0 million in 2005. No dividends were paid in 2006. Applying the current regulatory restrictions as of December 31, 2007, $112.2 million would be available for distribution to us without prior approval after June 5, 2008. We anticipate no objections to the payment of the dividends described in the preceding sentence.

Notwithstanding the foregoing, if insurance regulators otherwise determine that payment of a dividend to an affiliate would be detrimental to an insurance subsidiary’s policyholders or creditors, because of the financial condition of the insurance subsidiary or otherwise, the regulators may block dividends to affiliates that would otherwise be permitted without prior approval.

Our subsidiaries are permitted under the terms of our indebtedness to incur additional indebtedness that may restrict or prohibit the making of distributions, the payment of dividends or the making of loans by our subsidiaries to us. We cannot assure you that the agreements governing the current and future indebtedness of our subsidiaries will permit our subsidiaries to provide us with sufficient dividends, distributions or loans to fund payments on these notes when due.

Although we have paid cash dividends in the past, we may not be able to pay cash dividends in the future.

We have a history of paying dividends to our shareholders when sufficient cash is available. However, future cash dividends will depend upon our results of operations, financial condition, cash requirements and other factors, including the ability of our subsidiaries to make distributions to us, which ability is restricted in the manner previously discussed in this section. Also, there can be no assurance that we will continue to pay dividends even if the necessary financial conditions are met and if sufficient cash is available for distribution.



43



If our technology initiatives are not successful, or the benefits are not realized, our business could be adversely affected.

Our businesses are increasingly dependent on technology. Our inability to anticipate or manage problems with technology, or fully realize the expected benefits from investments in technology, could adversely affect our ability to write business, and could adversely impact our financial results.

If we lose our key personnel our business could be adversely affected.

The success of our business is dependent, to a large extent, on our ability to attract and retain key employees, in particular our senior officers, and key management, sales, information systems, underwriting, claims and corporate personnel. Competition to attract and retain key personnel is intense. Although we have change of control agreements with a number of key managers, in general, we do not have employment contracts or non-compete arrangements with, or key person insurance covering, our employees, including our key employees.

Applicable insurance laws and certain provisions in our certificate of incorporation make it difficult to effect a change of control of our Company, and the Mutual Company has significant influence over potential change of control transactions, which could affect our share value.

Under applicable insurance laws and regulations of the states in which our subsidiaries are domiciled, no person may acquire control of us unless that person has filed a statement containing specified information with the insurance commissioner of each state and obtains advance approval for such acquisition. Under applicable laws and regulations, any person acquiring, directly or indirectly (by revocable proxy or otherwise), 10% or more of the voting stock of any other person is presumed to have acquired control of such person, and a person who beneficially acquires 10% or more of our common stock without obtaining advance approval of the insurance commissioner of each state would be in violation of applicable insurance laws and would be subject to injunctive action requiring disposition or seizure of the shares and prohibiting the voting of such shares, as well as other action determined by the insurance commissioner of each such state.

In addition, many state insurance laws require prior notification to the state insurance department of a change of control of a non-domiciliary insurance company licensed to transact an insurance business in that state. Although these pre-notification statutes do not authorize the state insurance departments to disapprove the change of control, they authorize regulatory action – including a possible revocation of our authority to do business – in the affected state if particular conditions exist such as undue market concentration. Any future transactions that would constitute a change of control of us may require prior notification in the states that have pre-acquisition notification laws.

As of December 31, 2007, the Mutual Company owned approximately 53% of our outstanding common stock. The Mutual Company’s stock ownership and ability, by reason of such ownership, to elect our board of directors, provides it with significant influence over potential change of control transactions. Section 203 of the Delaware General Corporation Law provides, however, that if a person acquires 15% or more of our voting stock, the person is an “interested stockholder” and may not engage in “business combinations” with us for a period of three years from the time the person acquired 15% or more of our voting stock, subject to certain exceptions.

Finally, our certificate of incorporation permits our board of directors to issue up to one million shares of preferred stock having such terms, including voting rights, as the board of directors shall fix and determine.



44



Item 7A.

Quantitative and Qualitative Disclosures about Market Risk.

Interest Rate Risk

Harleysville Group’s exposure to market risk for changes in interest rates is concentrated in its investment portfolio and, to a lesser extent, its debt obligations. Harleysville Group monitors this exposure through periodic reviews of asset and liability positions. Estimates of cash flows and the impact of interest rate fluctuations relating to the investment portfolio are modeled regularly.

Principal cash flows and related weighted-average interest rates by expected maturity dates for financial instruments sensitive to interest rates are as follows:

 

 

December 31, 2007

 

 

 

Principal

Cash Flows

 

Weighted-Average

Interest Rate

 

 

 

(dollars in thousands)

 

Fixed maturities and short-term investments: 

  

 

 

 

 

 

 

2008

 

$

375,479

 

 

5.03%

 

2009

 

 

210,938

 

 

4.67%

 

2010

 

 

214,825

 

 

4.79%

 

2011

 

 

240,104

 

 

5.47%

 

2012

 

 

268,659

 

 

5.27%

 

Thereafter

 

 

930,496

 

 

5.20%

 

Total

 

$

2,240,501

 

 

 

 

Fair value

 

$

2,285,643

 

 

 

 

Securities lending collateral:

 

 

 

 

 

 

 

2008

 

$

86,956

 

 

4.64%

 

2009

 

 

31,447

 

 

3.48%

 

2010

 

 

5,155

 

 

4.62%

 

Total

 

$

123,558

 

 

 

 

Fair value

 

$

122,053

 

 

 

 

Debt:

 

 

 

 

 

 

 

2012

 

$

18,500

 

 

5.68%

 

2013

 

 

100,000

 

 

5.75%

 

Total

 

$

118,500

 

 

 

 

Fair value

 

$

116,382

 

 

 

 

Securities lending obligation:

 

 

 

 

 

 

 

2008

 

$

123,542

 

 

4.23%

 

Fair value

 

$

123,542

 

 

 

 

Actual cash flows may differ from those stated as a result of calls and prepayments.

Equity Price Risk

Harleysville Group’s portfolio of equity securities, which is carried on the balance sheet at fair value, has exposure to price risk. Price risk is defined as the potential loss in fair value resulting from an adverse change in prices. Portfolio characteristics are analyzed regularly and price risk is actively managed through a variety of techniques.

The combined total of realized and unrealized equity investment gains was $3.5 million, $8.6 million and $1.2 million in 2007, 2006 and 2005, respectively. During these three years, the largest total equity investment gain and (loss) in a quarter was $7.0 million (1st quarter 2006) and $(5.8) million (2nd quarter 2006), respectively.



45



Item 8.

Financial Statements and Supplementary Data.

 

 

Page

  

Consolidated Financial Statements

 

 

Consolidated Balance Sheets as of December 31, 2007 and 2006

47

 

Consolidated Statements of Income for Each of the Years
in the Three-year Period Ended December 31, 2007

48

 

Consolidated Statements of Shareholders’ Equity for Each of the
Years in the Three-year Period Ended December 31, 2007

49

 

Consolidated Statements of Cash Flows for Each of the Years in
the Three-year Period Ended December 31, 2007

51

 

Notes to Consolidated Financial Statements

52

 

Report of Independent Registered Public Accounting Firm

75





46



HARLEYSVILLE GROUP

CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)


 

 

December 31,

 

 

 

2007

 

2006

 

Assets

  

 

 

 

 

 

 

Investments:

 

 

 

 

 

 

 

Fixed maturities:

 

 

 

 

 

 

 

Held to maturity, at amortized cost (fair value $317,091 and $377,348)

 

$

313,629

 

$

378,049

 

Available for sale, at fair value (amortized cost $1,715,219 and $1,600,940)

 

 

1,740,045

 

 

1,606,333

 

Equity securities, at fair value (cost $66,433 and $62,932)

 

 

76,297

 

 

71,446

 

Short-term investments, at cost, which approximates fair value

 

 

107,941

 

 

72,237

 

Fixed maturity securities on loan:

 

 

 

 

 

 

 

Held to maturity, at amortized cost (fair value $2,419 and $4,487)

 

 

2,414

 

 

4,408

 

Available for sale, at fair value (amortized cost $116,047 and $116,711)

 

 

118,147

 

 

116,541

 

Total investments

 

 

2,358,473

 

 

2,249,014

 

Cash

 

 

412

 

 

227

 

Receivables:

 

 

 

 

 

 

 

Premiums

 

 

146,238

 

 

147,445

 

Reinsurance

 

 

167,671

 

 

167,199

 

Accrued investment income

 

 

26,220

 

 

25,823

 

Total receivables

 

 

340,129

 

 

340,467

 

Deferred policy acquisition costs

 

 

101,954

 

 

102,317

 

Prepaid reinsurance premiums

 

 

38,721

 

 

37,242

 

Property and equipment, net

 

 

13,475

 

 

16,690

 

Deferred income taxes

 

 

38,544

 

 

60,643

 

Securities lending collateral

 

 

122,053

 

 

124,755

 

Due from affiliate

 

 

7,197

 

 

5,716

 

Other assets

 

 

51,487

 

 

53,913

 

Total assets

 

$

3,072,445

 

$

2,990,984

 

Liabilities and Shareholders’ Equity

 

 

 

 

 

 

 

Liabilities:

 

 

 

 

 

 

 

Unpaid losses and loss settlement expenses (affiliate $149,826 and $178,327)

 

$

1,546,690

 

$

1,493,645

 

Unearned premiums (affiliate $28,555 and $33,850)

 

 

450,186

 

 

443,738

 

Accounts payable and accrued expenses

 

 

74,686

 

 

98,184

 

Securities lending obligation

 

 

123,542

 

 

124,755

 

Debt (affiliate $18,500 and $18,500)

 

 

118,500

 

 

118,500

 

Total liabilities

 

 

2,313,604

 

 

2,278,822

 

Shareholders’ equity:

 

 

 

 

 

 

 

Preferred stock, $1 par value, authorized 1,000,000 shares; none issued

 

 

 

 

 

 

 

Common stock, $1 par value, authorized 80,000,000 shares; issued 2007, 33,656,253 and 2006, 33,060,600 shares; outstanding 2007, 30,322,905 and 2006, 31,662,691 shares

 

 

33,656

 

 

33,061

 

Additional paid-in capital

 

 

213,654

 

 

197,607

 

Accumulated other comprehensive income

 

 

20,599

 

 

14

 

Retained earnings

 

 

578,705

 

 

505,967

 

Treasury stock, at cost, 3,333,348 and 1,397,909 shares

 

 

(87,773

)

 

(24,487

)

Total shareholders’ equity

 

 

758,841

 

 

712,162

 

Total liabilities and shareholders’ equity

 

$

3,072,445

 

$

2,990,984

 



See accompanying notes to consolidated financial statements.

47



HARLEYSVILLE GROUP

CONSOLIDATED STATEMENTS OF INCOME

(in thousands, except per share data)


 

 

Year Ended December 31,

 

 

 

2007

 

2006

 

2005

 

Revenues:

 

 

 

 

 

 

 

 

 

 

Premiums earned from affiliate (ceded to affiliate, $753,806, $742,752 and $749,085)

 

$

833,024

 

$

838,821

 

$

841,567

 

Investment income, net of investment expense

 

 

110,827

 

 

102,609

 

 

90,572

 

Realized investment gains, net

 

 

875

 

 

40,605

 

 

233

 

Other income (affiliate $6,303, $6,420 and $6,697)

 

 

17,286

 

 

17,136

 

 

15,968

 

Total revenues

 

 

962,012

 

 

999,171

 

 

948,340

 

Expenses:

 

 

 

 

 

 

 

 

 

 

Losses and loss settlement expenses (ceded to affiliate, $490,058, $482,783 and $490,339)

 

 

523,030

 

 

539,823

 

 

567,396

 

Amortization of deferred policy acquisition costs

 

 

207,684

 

 

212,872

 

 

210,665

 

Other underwriting expenses

 

 

76,223

 

 

78,208

 

 

79,367

 

Interest expense (affiliate $1,057, $1,016 and $699)

 

 

7,085

 

 

6,943

 

 

6,648

 

Other expenses

 

 

4,995

 

 

4,957

 

 

5,343

 

Total expenses

 

 

819,017

 

 

842,803

 

 

869,419

 

Income before income taxes and cumulative effect of accounting change

 

 

142,995

 

 

156,368

 

 

78,921

 

Income taxes

 

 

42,941

 

 

46,241

 

 

17,490

 

Income before cumulative effect of accounting change

 

 

100,054

 

 

110,127

 

 

61,431

 

Cumulative effect of accounting change, net of income taxes

 

 

 

 

 

942

 

 

 

 

Net income

 

$

100,054

 

$

111,069

 

$

61,431

 

Per common share:

 

 

 

 

 

 

 

 

 

 

Basic income before cumulative effect of accounting change

 

$

3.24

 

$

3.55

 

$

2.02

 

Basic cumulative effect of accounting change

 

 

 

 

 

.03

 

 

 

 

Basic net income

 

$

3.24

 

$

3.58

 

$

2.02

 

Diluted income before cumulative effect of accounting change

 

$

3.19

 

$

3.49

 

$

2.01

 

Diluted cumulative effect of accounting change

 

 

 

 

 

.03

 

 

 

 

Diluted net income

 

$

3.19

 

$

3.52

 

$

2.01

 

Cash dividend

 

$

.88

 

$

.73

 

$

.69

 






See accompanying notes to consolidated financial statements.

48



HARLEYSVILLE GROUP

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

For the years ended December 31, 2007, 2006 and 2005

(dollars in thousands)


 

 

 

Common Stock

 

Additional

Paid-in

Capital

 

Accumulated

Other

Comprehensive

Income

 

Retained

Earnings

 

Deferred

Compensation

 

Treasury

Stock

 

Total

 


Shares

 

Amount

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance at December 31, 2004

 

 

31,589,474

 

$

31,589

 

$

161,689

 

$

42,051

 

$

377,282

 

$

(200

)

$

(24,487

)

$

587,924

 

Net income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

61,431

 

 

 

 

 

 

 

 

61,431

 

Other comprehensive loss, net of tax:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Unrealized investment losses, net of reclassifi-cation adjustment

 

 

 

 

 

 

 

 

 

 

 

(20,896

)

 

 

 

 

 

 

 

 

 

 

(20,896

)

Minimum pension liability adjustment

 

 

 

 

 

 

 

 

 

 

 

(867

)

 

 

 

 

 

 

 

 

 

 

(867

)

Other comprehensive loss

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(21,763

)

Comprehensive income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

39,668

 

Issuance of common stock:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Incentive plans

 

 

392,417

 

 

393

 

 

7,067

 

 

 

 

 

 

 

 

 

 

 

 

 

 

7,460

 

Dividend Reinvestment
Plan

 

 

26,251

 

 

26

 

 

561

 

 

 

 

 

 

 

 

 

 

 

 

 

 

587

 

Tax benefit from stock options exercised

 

 

 

 

 

 

 

 

564

 

 

 

 

 

 

 

 

 

 

 

 

 

 

564

 

Cash dividends paid

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(21,008

)

 

 

 

 

 

 

 

(21,008

)

Deferred compensation

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(812

)

 

 

 

 

(812

)

Balance at December 31, 2005

 

 

32,008,142

 

 

32,008

 

 

169,881

 

 

20,288

 

 

417,705

 

 

(1,012

)

 

(24,487

)

 

614,383

 

Net income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

111,069

 

 

 

 

 

 

 

 

111,069

 

Other comprehensive loss, net of tax:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Unrealized investment losses, net of reclassifi- cation adjustment

 

 

 

 

 

 

 

 

 

 

 

(25,189

)

 

 

 

 

 

 

 

 

 

 

(25,189

)

Minimum pension liability adjustment

 

 

 

 

 

 

 

 

 

 

 

4,915

 

 

 

 

 

 

 

 

 

 

 

4,915

 

Other comprehensive loss

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(20,274

)

Comprehensive income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

90,795

 

Issuance of common stock:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Incentive plans

 

 

1,033,472

 

 

1,034

 

 

20,359

 

 

 

 

 

 

 

 

 

 

 

 

 

 

21,393

 

Dividend Reinvestment
Plan

 

 

18,986

 

 

19

 

 

592

 

 

 

 

 

 

 

 

 

 

 

 

 

 

611

 

Tax benefit from stock compensation

 

 

 

 

 

 

 

 

3,258

 

 

 

 

 

 

 

 

 

 

 

 

 

 

3,258

 

Stock compensation

 

 

 

 

 

 

 

 

4,529

 

 

 

 

 

 

 

 

 

 

 

 

 

 

4,529

 

Reclassification of deferred
compensation

 

 

 

 

 

 

 

 

(1,012

)

 

 

 

 

 

 

 

1,012

 

 

 

 

 

 

 

Cash dividends paid

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(22,807

)

 

 

 

 

 

 

 

(22,807

)

Balance at December 31, 2006

 

 


33,060,600

 

$


33,061

 

$


197,607

 

$

14

 

$


505,967

 

$


 

$


(24,487

)

$


712,162

 




(Continued)

49



HARLEYSVILLE GROUP

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

For the years ended December 31, 2007, 2006 and 2005

(dollars in thousands)

(Continued)


 

 

 

Common Stock

 

Additional

Paid-in

Capital

 

Accumulated

Other

Comprehensive

Income

 

Retained

Earnings

 

Treasury

Stock

 

Total

 

Shares

 

Amount

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

$

 

 

$

 

 

$

 

 

$

100,054

 

$

 

 

$

100,054

 

Other comprehensive income, net of tax:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Unrealized investment gains, net of reclassification adjustment

 

 

 

 

 

 

 

 

 

 

 

14,556

 

 

 

 

 

 

 

 

14,556

 

Defined benefit pension plans: Net actuarial loss adjustment

 

 

 

 

 

 

 

 

 

 

 

6,029

 

 

 

 

 

 

 

 

6,029

 

Other comprehensive income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

20,585

 

Comprehensive income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

120,639

 

Issuance of common stock:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Incentive plans

 

 

576,571

 

 

576

 

 

8,214

 

 

 

 

 

 

 

 

 

 

 

8,790

 

Dividend Reinvestment Plan

 

 

19,082

 

 

19

 

 

613

 

 

 

 

 

 

 

 

 

 

 

632

 

Tax benefit from stock compensation

 

 

 

 

 

 

 

 

2,497

 

 

 

 

 

 

 

 

 

 

 

2,497

 

Stock compensation

 

 

 

 

 

 

 

 

4,723

 

 

 

 

 

 

 

 

 

 

 

4,723

 

Purchase of treasury stock, 1,935,439 shares

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(63,286

)

 

(63,286

)

Cash dividends paid

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(27,316

)

 

 

 

 

(27,316

)

Balance at December 31, 2007

 

 


33,656,253

 

$

33,656

 

$


213,654

 

$

20,599

 

$

578,705

 

$


(87,773

)

$


758,841

 





See accompanying notes to consolidated financial statements.

50



HARLEYSVILLE GROUP

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)


 

 

Year Ended December 31,

 

 

 

2007

 

2006

 

2005

 

 

 

 

 

 

 

 

 

 

 

 

Cash flows from operating activities:

 

 

 

 

 

 

 

 

 

 

Net income

 

$

100,054

 

$

111,069

 

$

61,431

 

Adjustments to reconcile net income
to net cash provided by operating activities:

 

 

 

 

 

 

 

 

 

 

Cumulative effect of accounting change, net of tax

 

 

 

 

 

(942

)

 

 

 

Change in receivables, unearned premiums and
prepaid reinsurance

 

 

5,307

 

 

74,448

 

 

(59,395

)

Change in affiliate balance

 

 

(1,481

)

 

(4,694

)

 

(13,520

)

Increase in unpaid losses and loss settlement expenses

 

 

53,045

 

 

12,843

 

 

163,067

 

Deferred income taxes

 

 

11,013

 

 

13,123

 

 

1,499

 

Decrease (increase) in deferred policy acquisition costs

 

 

363

 

 

1,856

 

 

(3,418

)

Amortization and depreciation

 

 

4,192

 

 

4,291

 

 

5,097

 

Realized investment gains, net

 

 

(875

)

 

(40,605

)

 

(233

)

Change in other assets and other liabilities

 

 

(2,135

)

 

(11,289

)

 

9,706

 

Other, net

 

 

2,043

 

 

5,965

 

 

859

 

Net cash provided by operating activities

 

 

171,526

 

 

166,065

 

 

165,093

 

Cash flows from investing activities:

 

 

 

 

 

 

 

 

 

 

Held to maturity investments:

 

 

 

 

 

 

 

 

 

 

Maturities

 

 

63,284

 

 

58,219

 

 

58,638

 

Available for sale investments:

 

 

 

 

 

 

 

 

 

 

Purchases

 

 

(309,760

)

 

(575,900

)

 

(416,763

)

Maturities

 

 

164,258

 

 

170,954

 

 

122,097

 

Sales

 

 

20,600

 

 

186,254

 

 

35,990

 

Net (purchases) sales or maturities of short-term investments

 

 

(35,704

)

 

(7,918

)

 

49,503

 

Sale (purchase) of property and equipment, net

 

 

4,659

 

 

(375

)

 

743

 

Net cash used by investing activities

 

 

(92,663

)

 

(168,766

)

 

(149,792

)

Cash flows from financing activities:

  

 

 

 

 

 

 

 

 

 

Issuance of common stock

 

 

9,427

 

 

22,011

 

 

6,970

 

Purchase of treasury stock

 

 

(63,286

)

 

 

 

 

 

 

Repayment of debt

 

 

 

 

 

 

 

 

(1,125

)

Dividends paid (to affiliate, $14,449, $12,412 and $11,732)

 

 

(27,316

)

 

(22,807

)

 

(21,008

)

Excess tax benefits from share-based payment arrangements

 

 

2,497

 

 

3,258

 

 

 

 

Net cash (used) provided by financing activities

 

 

(78,678

)

 

2,462

 

 

(15,163

)

Increase (decrease) in cash

 

 

185

 

 

(239

)

 

138

 

Cash at beginning of year

 

 

227

 

 

466

 

 

328

 

Cash at end of year

 

$

412

 

$

227

 

$

466

 




See accompanying notes to consolidated financial statements.

51



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1 - Description of Business and Summary of Significant Accounting Policies

Description of Business

Harleysville Group consists of Harleysville Group Inc. and its subsidiaries (all wholly owned). Those subsidiaries are:

-

Harleysville-Atlantic Insurance Company (Atlantic)

-

Harleysville Insurance Company (HIC)

-

Harleysville Insurance Company of New Jersey (HNJ)

-

Harleysville Insurance Company of New York (HIC New York)

-

Harleysville Insurance Company of Ohio (HIC Ohio)

-

Harleysville Lake States Insurance Company (Lake States)

-

Harleysville Preferred Insurance Company (Preferred)

-

Harleysville Worcester Insurance Company (Worcester)

-

Mid-America Insurance Company (Mid-America) - merged into Worcester in 2007

-

Harleysville Ltd., a real estate partnership that owns the home office

Harleysville Group is approximately 53% owned by Harleysville Mutual Insurance Company (Mutual).

Harleysville Group underwrites property and casualty insurance in both the personal and commercial lines of insurance. The personal lines of insurance include both auto and homeowners, and the commercial lines include auto, commercial multi-peril and workers compensation. The business is marketed primarily in the eastern and midwestern United States through independent agents.

Principles of Consolidation and Basis of Presentation

The accompanying financial statements include the accounts of Harleysville Group prepared in conformity with U.S. generally accepted accounting principles, which differ in some respects from those followed in reports to insurance regulatory authorities. All significant intercompany balances and transactions have been eliminated in consolidation.

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, including loss and loss settlement expenses, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses, including the determination of other-than-temporary declines in investments, during the reporting period. Actual results could differ from these estimates.

Investments

Accounting for fixed maturities depends on their classification as held to maturity, available for sale or trading. Fixed maturities classified as held to maturity are carried at amortized cost. Fixed maturities classified as available for sale are carried at fair value. There were no investments classified as trading. Equity securities are carried at fair value. Short-term investments are recorded at cost, which approximates fair value. The fair value of fixed maturities is based upon data supplied by an independent pricing service. The fair value of equity securities is based on the closing market value. The fair value of mutual fund holdings is based on the closing net asset value reported by the fund.

Premiums and discounts on fixed income securities are amortized or accreted using the interest method. Mortgage-backed securities are amortized over a period based on estimated future principal payments, including prepayments. Prepayment assumptions are reviewed periodically and adjusted as necessary to reflect actual prepayments and changes in expectations. Adjustments related to changes in prepayment assumptions are recognized on a retrospective basis.



52



Realized gains and losses on sales of investments are recognized in net income on the specific identification basis. A decline in the fair value of an investment below its cost that is deemed other than temporary is charged to earnings. Unrealized investment gains or losses on investments carried at fair value, net of applicable income taxes, are reflected directly in shareholders’ equity as a component of comprehensive income and, accordingly, have no effect on net income. However, if the fair value of an investment declines below its cost and that decline is deemed other than temporary, the amount of the decline below cost is charged to earnings. Harleysville Group monitors its investment portfolio and at least quarterly reviews investments that have experienced a decline in fair value below cost to evaluate whether the decline is other than temporary. Such evaluations consider, among other things, the magnitude and reasons for a decline, the prospects for the fair value to recover in the near term and Harleysville Group’s ability and intent to retain the investment for a period of time sufficient to allow for a recovery in value.

Premiums

Premiums are recognized as revenue ratably over the terms of the respective policies. Unearned premiums are calculated on a pro rata basis.

Policy Acquisition Costs

Policy acquisition costs, such as commissions, premium taxes and certain other underwriting and agency expenses that vary with, and are primarily related to, the production of business, are deferred and amortized over the effective period of the related insurance policies in proportion to the premiums earned. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. The estimation of net realizable value takes into account the premium to be earned, related investment income over the claims paying period, expected losses and loss settlement expenses, and certain other costs expected to be incurred as the premium is earned. Future changes in estimates, the most significant of which is expected losses and loss settlement expenses, may require adjustments to deferred policy acquisition costs. If the estimation of net realizable value indicates that the acquisition costs are unrecoverable, further analyses are completed to determine if a reserve is required to provide for losses that may exceed the related unearned premiums.

Losses and Loss Settlement Expenses

The liability for losses and loss settlement expenses represents estimates of the ultimate unpaid cost of all losses incurred, which includes the gross liabilities to Harleysville Group’s policyholders plus the net liability to Mutual under the pooling agreement. See Note 2(a). Such estimates may be more or less than the amounts ultimately paid when the claims are settled. These estimates are periodically reviewed and adjusted as necessary; such adjustments are reflected in current operations.

Share-Based Payments

Harleysville Group has several share-based compensation plans. Harleysville Group had accounted for the plans under the provisions of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Accordingly, no compensation expense was recognized prior to 2006 for fixed stock option grants and an employee stock purchase plan. Effective January 1, 2006, Harleysville Group adopted Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), “Share-Based Payment” (SFAS No. 123(R)), which replaced SFAS No. 123 and supercedes APB Opinion No. 25, using the modified prospective application provisions. SFAS No. 123(R) requires that the cost resulting from all share-based payment transactions be recognized in the financial statements.

Implementing SFAS No. 123(R) did not have a material effect on income before cumulative effect of accounting change and basic or diluted earnings per share before cumulative effect of accounting change in the year ended December 31, 2006. A cumulative effect of change in accounting benefit of $942,000, net of tax of $507,000, was recorded in the first quarter of 2006 related to the accounting for the Long Term Incentive Plan (LTIP). The LTIP has a cash component and a stock component which awards shares based on the total shareholder return of the Company’s stock relative to the total shareholder return of a group of insurance company stocks. Under APB Opinion No. 25, this plan had been accounted for using the intrinsic method. Under SFAS No. 123(R), the cash component is accounted for under the liability method and the stock component is accounted for as an equity instrument.



53



The following table illustrates the effect on net income and earnings per share as if the provisions of SFAS No. 123 (as amended by SFAS No. 148), “Accounting for Stock-Based Compensation,” had been applied to in 2005.

 

 

 

2005

 

 

 

 

 

(in thousands,

except per share data)

 

 

Net income, as reported

 

$

61,431

 

 

 

Plus: Stock-based employee compensation expense included in reported net income, net of related tax effects

 

 

799

 

 

 

Less: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects

 

 

(2,934

)

 

 

Pro forma net income

 

$

59,296

 

 

 

Basic earnings per share:

 

 

 

 

 

 

As reported

 

$

2.02

 

 

 

Pro forma

 

$

1.95

 

 

 

Diluted earnings per share:

 

 

 

 

 

 

As reported

 

$

2.01

 

 

 

Pro forma

 

$

1.94

 

 

Property and Equipment

Property and equipment are carried at cost less accumulated depreciation. Depreciation is calculated primarily on the straight-line basis over the estimated useful lives of the assets (up to 40 years for buildings and three to 15 years for equipment).

Income Taxes

Deferred income tax assets and liabilities are recognized for the expected future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.

Earnings Per Share

Basic earnings per share is computed by dividing earnings by the weighted-average number of common shares outstanding during the year. Diluted earnings per share includes the dilutive effect of the stock incentive plans described in Note 10.

New Accounting Standards

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” This statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. This statement applies under other accounting pronouncements that require or permit fair value measurements. The statement is effective for financial statements issued for fiscal years beginning after November 15, 2007. The impact of adopting this statement on Harleysville Group’s results of operations and financial condition is not expected to be material.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities--Including an amendment of FASB Statement No. 115.” SFAS No. 159 permits companies to choose to measure many financial instruments and certain other items at fair value at specified election dates. Upon adoption, an entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. Most of the provisions apply only to entities that elect the fair value option. However, the amendment to SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” applies to all entities with available for sale and trading securities. SFAS No. 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. The impact of adopting this statement on Harleysville Group’s results of operations and financial condition is not expected to be material.



54



2 - Transactions with Affiliates

(a) Underwriting

The insurance subsidiaries participate in a reinsurance pooling agreement with Mutual whereby such subsidiaries cede to Mutual all of their insurance business and assume from Mutual an amount equal to their participation in the pooling agreement. All losses and loss settlement expenses and other underwriting expenses are prorated among the parties on the basis of participation in the pooling agreement. The agreement pertains to all insurance business written or earned on or after January 1, 1986. Harleysville Group’s participation was 72% for 2007, 2006, and 2005.

Effective January 1, 2008, the Company’s property and casualty subsidiaries and Mutual and its property and casualty subsidiary, Harleysville Pennland Insurance Company (Pennland) amended their intercompany pooling agreement to increase Harleysville Group’s share of the pool from 72% to 80%. Harleysville Group received cash and investments of $192.1 million on January 3, 2008 associated with the transfer of assets and liabilities from the Mutual Company and Pennland to Harleysville Group in connection with the pool change.

Because this pooling agreement does not relieve Harleysville Group of primary liability as the originating insurer, there is a concentration of credit risk arising from business ceded to Mutual. However, the reinsurance pooling agreement provides for the right of offset, and the amount of credit risk with Mutual was not material at December 31, 2007 and 2006. Mutual has an A. M. Best rating of “A-” (Excellent).

The following amounts represent reinsurance transactions between Harleysville Group and Mutual under the pooling arrangement:

 

 

2007

 

2006

 

2005

 

 

 

(in thousands)

 

Ceded:

 

 

 

 

 

 

 

 

 

 

Premiums written

 

$

764,070

 

$

750,516

 

$

743,170

 

Premiums earned

 

$

753,806

 

$

742,752

 

$

740,273

 

Losses incurred

 

$

490,058

 

$

482,599

 

$

490,517

 

Assumed:

 

 

 

 

 

 

 

 

 

 

Premiums written

 

$

837,993

 

$

838,817

 

$

847,856

 

Premiums earned

 

$

833,024

 

$

838,821

 

$

850,379

 

Losses incurred

 

$

522,735

 

$

539,213

 

$

566,770

 

Net assumed from Mutual:

 

 

 

 

 

 

 

 

 

 

Unearned premiums

 

$

28,555

 

$

33,850

 

$

41,618

 

Unpaid losses and loss
settlement expenses

 

$

149,826

 

$

178,327

 

$