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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended MARCH 31, 2003.
-----------------
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
------------ --------------
Commission file number 0-14697
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HARLEYSVILLE GROUP INC.
--------------------------------------------------------------
(Exact name of registrant as specified in its charter)
DELAWARE 51-0241172
- ----------------------------------- ---------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
355 MAPLE AVENUE, HARLEYSVILLE, PENNSYLVANIA 19438-2297
------------------------------------------------------------------
(Address of principal executive offices, including zip code)
(215) 256-5000
--------------------------------------------------------
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days.
Yes X . No .
----- -----
At May 6, 2003, 30,150,885 shares of common stock of Harleysville Group
Inc. were outstanding.
Page 1
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
INDEX
PAGE NUMBER
-----------
Part I - Financial Information
Consolidated Balance Sheets - March 31, 2003
and December 31, 2002 3
Consolidated Statements of Income - For the
three months ended March 31, 2003 and 2002 4
Consolidated Statement of Shareholders' Equity -
For the three months ended March 31, 2003 5
Consolidated Statements of Cash Flows -
For the three months ended March 31, 2003
and 2002 6
Notes to Consolidated Financial Statements 7
Management's Discussion and Analysis of Results
of Operations and Financial Condition 13
Quantitative and Qualitative Disclosure About
Market Risk 23
Evaluation of Disclosure Controls and Procedures 24
Part II - Other Information 25
Page 2
ITEM 1. FINANCIAL STATEMENTS
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
MARCH 31, DECEMBER 31,
2003 2002
---------- -----------
(Unaudited)
ASSETS
------
Investments:
Fixed maturities:
Held to maturity, at amortized cost
(fair value $377,648 and $411,235) $ 347,189 $ 379,940
Available for sale, at fair value
(amortized cost $1,005,085 and $932,889) 1,064,653 95,032
Equity securities, at fair value
(cost $93,633 and $96,849) 102,119 107,177
Short-term investments, at cost,
which approximates fair value 101,441 89,692
Fixed maturity securities on loan:
Held to maturity, at amortized
cost (fair value $6,179 and $5,707) 5,543 5,222
Available for sale, at fair value
(amortized cost $117,679 and $118,991) 127,280 129,837
---------- ----------
Total investments 1,748,225 1,706,900
Cash 2,491 2,944
Receivables:
Premiums 140,306 138,905
Reinsurance (affiliate $3,666 and $55) 88,237 75,488
Accrued investment income 20,505 21,552
---------- ----------
Total receivables 249,048 235,945
Deferred policy acquisition costs 99,255 94,896
Prepaid reinsurance premiums 20,037 19,421
Property and equipment, net 26,363 27,556
Deferred income taxes 31,821 25,784
Security lending collateral 137,702 139,215
Due from affiliate 10,709
Other assets 52,296 48,154
---------- ----------
Total assets $2,367,238 $2,311,524
========== ==========
LIABILITIES AND SHAREHOLDERS' EQUITY
------------------------------------
Liabilities:
Unpaid losses and loss settlement expenses
(affiliate $177,849 and $166,188) $ 977,761 $ 928,335
Unearned premiums (affiliate $64,401 and $54,035) 423,347 406,277
Accounts payable and accrued expenses 106,867 109,965
Security lending obligation 137,702 139,215
Debt (affiliate $18,500) 95,620 95,620
Due to affiliate 2,417
---------- ----------
Total liabilities 1,743,714 1,679,412
---------- ----------
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 31,157,811
and 30,917,575 shares; outstanding
30,139,312 and 29,917,575 shares 31,158 30,918
Additional paid-in capital 154,938 149,091
Accumulated other comprehensive income 45,406 49,086
Retained earnings 410,370 418,582
Deferred compensation (2,356)
Treasury stock, at cost, 1,018,499
and 1,000,000 shares (15,992) (15,565)
---------- ----------
Total shareholders' equity 623,524 632,112
---------- ----------
Total liabilities and
shareholders' equity $2,367,238 $2,311,524
========== ==========
See accompanying notes to consolidated financial statements.
Page 3
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
FOR THE THREE MONTHS ENDED MARCH 31, 2003 AND 2002
(dollars in thousands, except per share data)
2003 2002
-------- --------
Revenues:
Premiums earned (ceded to affiliate, $198,829 $182,505
$172,305 and $160,271)
Investment income, net of
investment expense 21,447 21,482
Realized investment gains (losses) (433) 478
Other income (affiliate $2,010 and
$1,754) 4,520 3,745
-------- --------
Total revenues 224,363 208,210
-------- --------
Losses and expenses:
Losses and loss settlement expenses
(ceded to affiliate, $142,882 and
$113,667) 163,759 127,272
Amortization of deferred policy
acquisition costs 48,317 44,622
Other underwriting expenses 18,557 16,922
Interest expense (affiliate $94 and
$120) 1,394 1,421
Other expenses 1,211 1,050
-------- --------
Total expenses 233,238 191,287
-------- --------
Income (loss) before income
taxes (8,875) 16,923
Income taxes (benefit) (5,635) 3,583
-------- --------
Net income (loss) $ (3,240) $ 13,340
======== ========
Per common share:
Basic earnings (loss) $ (.11) $ .45
======== ========
Diluted earnings (loss) $ (.11) $ .44
======== ========
Cash dividend $ .165 $ .15
======== ========
See accompanying notes to consolidated financial statements.
Page 4
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
(UNAUDITED)
FOR THE THREE MONTHS ENDED MARCH 31, 2003
(dollars in thousands)
ACCUMULATED
COMMON STOCK ADDITIONAL OTHER
------------------- PAID-IN COMPREHENSIVE RETAINED DEFERRED TREASURY
SHARES AMOUNT CAPITAL INCOME EARNINGS COMPENSATION STOCK TOTAL
---------- ------- ---------- ------------- -------- ------------ -------- --------
Balance,
December 31,
2002 30,917,575 $30,918 $149,091 $49,086 $418,582 $ $(15,565) $632,112
--------
Net loss (3,240) (3,240)
Other compre-
hensive loss,
net of tax:
Unrealized
investment
losses, net of
reclassification
adjustment (3,680) (3,680)
--------
Comprehensive
loss (6,920)
Issuance
of common
stock 240,236 240 5,840 6,080
Tax benefit
from stock
options
exercised 7 7
Deferred
compensation (2,356) (2,356)
Cash
dividend
paid (4,972) (4,972)
Purchase of
treasury
stock,
18,499
shares (427) (427)
---------- ------- -------- ------- -------- ------- -------- --------
Balance at
March 31,
2003 31,157,811 $31,158 $154,938 $45,406 $410,370 $(2,356) $(15,992) $623,524
========== ======= ======== ======= ======== ======= ======== ========
See accompanying notes to consolidated financial statements.
Page 5
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
FOR THE THREE MONTHS ENDED MARCH 31, 2003 AND 2002
(in thousands)
2003 2002
--------- --------
Cash flows from operating activities:
Net income (loss) $ (3,240) $ 13,340
Adjustments to reconcile net income
to net cash provided by operating
activities:
Change in receivables, unearned
premiums, prepaid reinsurance
balances 3,351 6,161
Change in affiliate balance 13,126 (11,477)
Increase in unpaid losses and
loss settlement expenses 49,426 10,639
Deferred income taxes (4,056) (308)
Increase in deferred policy
acquisition costs (4,359) (2,635)
Amortization and depreciation 844 595
Loss (gain) on sale of investments 433 (478)
Other, net (18,066) 9,110
-------- --------
Net cash provided by
operating activities 37,459 24,947
-------- --------
Cash flows from investing activities:
Fixed maturity investments:
Purchases (97,495) (61,721)
Sales or maturities 68,431 50,395
Equity securities:
Purchases (7,505)
Sales 1,923 5,757
Net purchases of short-term investments (11,749) (8,945)
Sale (purchase) of property and
equipment 297 (1,431)
-------- --------
Net cash used by
investing activities (38,593) (23,450)
-------- --------
Cash flows from financing activities:
Issuance of common stock 6,080 2,370
Dividend paid (to affiliates, $2,743
and $2,491) (4,972) (4,435)
Purchase of treasury stock (427)
-------- --------
Net cash provided (used)
by financing activities 681 (2,065)
-------- --------
Decrease in cash (453) (568)
Cash at beginning of period 2,944 1,839
-------- --------
Cash at end of period $ 2,491 $ 1,271
======== ========
See accompanying notes to consolidated financial statements.
Page 6
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
(UNAUDITED)
Notes to Consolidated Financial Statements
1 - Basis of Presentation
The financial information for the interim periods included herein is
unaudited; however, such information reflects all adjustments which are, in the
opinion of management, necessary to a fair presentation of the financial
position, results of operations, and cash flows for the interim periods. The
results of operations for interim periods are not necessarily indicative of
results to be expected for the full year.
These financial statements should be read in conjunction with the financial
statements and notes for the year ended December 31, 2002 included in the
Company's 2002 Annual Report filed with the Securities and Exchange Commission
on Form 10-K.
Policy Acquisition Costs
Policy acquisition costs, such as commissions, premium taxes and certain
other underwriting and agency expenses that vary with and are directly 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, 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
indicate 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.
Stock-Based Compensation
Stock-based compensation plans are accounted for under the provisions of
Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued
to Employees," and related interpretations. Accordingly, no compensation
expense is
Page 7
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
(UNAUDITED)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
recognized for fixed stock option grants and an employee stock purchase plan.
Compensation expense would be recorded on the date of a stock option grant only
if the current market price of the underlying stock exceeded the exercise price.
The following table illustrates the effect on net income and earnings per share
as if the provisions of statement of Financial Accounting Standards (SFAS) No.
123 (as amended by SFAS No. 148), "Accounting for Stock-Based Compensation," had
been applied for the three months ended March 31, 2003 and 2002:
2003 2002
-------- -------
(in thousands, except
per share data)
Net income (loss), as reported $(3,240) $13,340
Plus:
Stock-based employee
compensation expense included
in reported net income, net
of related tax effects 201 756
Less:
Total stock-based employee
compensation expense determined
under fair value based method
for all awards, net of related
tax effects (1,088) (1,273)
------- -------
Pro forma net income (loss) $(4,127) $12,823
======= =======
Basic earnings (loss) per share:
As reported $ (0.11) $ 0.45
Pro forma $ (0.14) $ 0.43
Diluted earnings (loss) per share:
As reported $ (0.11) $ 0.44
Pro forma $ (0.14) $ 0.43
Page 8
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
(UNAUDITED)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2 - Earnings Per Share
The computation of basic and diluted earnings (loss) per share is as
follows for the three months ended March 31:
2003 2002
---------- --------
(dollars in thousands,
except per share data)
Numerator for basic
and diluted earnings (loss)
per share:
Net income (loss) $ (3,240) $ 13,340
========= ========
Denominator for basic
earnings (loss) per share --
weighted average
shares outstanding 29,987,316 29,510,116
Effect of stock
incentive plans 552,462
---------- ----------
Denominator for
diluted earnings (loss)
per share 29,987,316 30,062,578
========== ==========
Basic earnings (loss)
per share $ (.11) $ .45
======= =======
Diluted earnings (loss)
per share $ (.11) $ .44
======= =======
Page 9
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
(UNAUDITED)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
The following options to purchase shares of common stock were not included
in the computation of diluted earnings (loss) per share because the exercise
price of the options was greater than the average market price:
FOR THE THREE MONTHS
ENDED MARCH 31,
2003 2002
-------- --------
(in thousands)
Number of options 904 433
=== ===
For the three months ended March 31, 2003, an additional 1,212,316 options
to purchase shares of common stock were not included in the computation of
diluted earnings (loss) per share because their inclusion would have had an
antidilutive effect.
3 - Reinsurance
Premiums earned are net of amounts ceded of $16,400,000 and $16,448,000 for
the three months ended March 31, 2003 and 2002, respectively. Losses and loss
settlement expenses are net of amounts ceded of $17,865,000 and $5,781,000 for
the three months ended March 31, 2003 and 2002, respectively. Such amounts do
not include the reinsurance transactions with Harleysville Mutual Insurance
Company (Mutual) under the pooling arrangement.
Harleysville Group has a reinsurance agreement with Mutual whereby Mutual
reinsures accumulated catastrophe losses in a quarter up to $14,400,000 in
excess of $3,600,000 in return for a reinsurance premium. The agreement
excludes catastrophe losses resulting from earthquakes, terrorism or hurricanes,
and supplements the existing external catastrophe reinsurance program. Under the
agreement, Harleysville Group ceded premiums earned of $2,024,000 and $1,791,000
and losses incurred of $3,756,000 and $28,000 to Mutual for the three months
ended March 31, 2003 and 2002, respectively.
Harleysville Group cedes business to and assumes business from Mutual under
a reinsurance pooling agreement. Because this 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. Mutual has
an A. M. Best rating of "A" (Excellent).
Page 10
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
(UNAUDITED)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
4 - Cash Flows
There were no cash tax payments in the first quarter of 2003 and 2002.
Cash interest payments of $94,000 and $122,000 were made in the first quarter of
2003 and 2002, respectively.
5 - Segment Information
The performance of the personal lines and commercial lines is evaluated
based upon underwriting results as determined under statutory accounting
practices (SAP).
Financial data by segment is as follows for the three months ended March
31, 2003 and 2002:
2003 2002
-------- --------
(in thousands)
Revenues:
Premiums earned:
Commercial lines $148,749 $128,305
Personal lines 50,080 54,200
-------- --------
Total premiums earned 198,829 182,505
Net investment income 21,447 21,482
Realized investment
gains (losses) (433) 478
Other 4,520 3,745
-------- --------
Total revenues $224,363 $208,210
======== ========
Income (loss) before income taxes:
Underwriting gain (loss):
Commercial lines $(28,006) $(10,164)
Personal lines (7,894) 1,424
-------- --------
SAP underwriting loss (35,900) (8,740)
GAAP adjustments 4,096 2,429
-------- --------
GAAP underwriting loss (31,804) (6,311)
Net investment income 21,447 21,482
Realized investment
gains (losses) (433) 478
Other 1,915 1,274
-------- --------
Income (loss) before income taxes $ (8,875) $ 16,923
======== ========
Page 11
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
(UNAUDITED)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
6 - Comprehensive Income
Comprehensive income (loss) for the three months ended March 31, 2003 and
2002 consisted of the following (all amounts are net of taxes):
2003 2002
-------- --------
(in thousands)
Net income (loss) $(3,240) $ 13,340
Other comprehensive loss:
Unrealized investment holding
losses arising during period (4,120) (10,682)
Less:
Reclassification adjustment
for (gains) losses included
in net income 440 (158)
------- --------
Net unrealized investment
losses (3,680) (10,840)
------- --------
Comprehensive income (loss) $(6,920) $ 2,500
======= ========
7 - Shareholders' Equity
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.
Page 12
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
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 and legislative 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 so that the
effect of future developments on Harleysville Group will be those anticipated by
management. Actual financial results including premium growth 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;
and the status of labor markets in which the Company operates.
Critical Accounting Policies and Estimates
The consolidated financial statements are prepared in conformity with
accounting principles generally accepted in the United States of America, which
require Harleysville Group to make estimates and assumptions (see Note 1 of the
Notes to Consolidated Financial Statements for the year ended December 31, 2002
included in the Company's 2002 Annual Report filed with the Securities and
Exchange Commission on Form 10-K). Harleysville Group believes that of its
significant accounting policies, the following may involve a higher degree of
judgment and estimation.
Liability 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
Page 13
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(CONTINUED)
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. Reserves are
closely monitored and are recomputed periodically using the most recent
information on reported claims and a variety of statistical 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 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 and the prospects for the
fair value to recover in the near term. Future adverse investment market
conditions, or poor operating results of underlying investments, could result in
an impairment charge in the future.
Harleysville Group evaluates its investment portfolio quarterly to
determine if a decline in fair value below cost is other than temporary.
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. For example, one equity security
had declined for a short period of time but was written down in the fourth
quarter of 2002 when the sale of the company at a value less than our cost was
announced. Fair value of equity securities is based on the closing market value
as reported by a national stock exchange or Nasdaq. 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.
Page 14
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
Policy Acquisition Costs. Policy acquisition costs, such as commissions,
premium taxes and certain other underwriting and agency expenses that vary with
and are directly 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, 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 indicate 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 not differ from those assessments.
The application of certain of these critical accounting policies to the
periods ended March 31, 2003 and 2002 is discussed in greater detail below.
Results of Operations
Premiums earned increased $16.3 million during the three months ended March
31, 2003 as compared to the three months ended March 31, 2002. The increase is
primarily due to an increase of $20.4 million in premiums earned for commercial
lines partially offset by a decline of $4.1 million in personal lines premiums
earned. The increase in premiums earned for commercial lines was 15.9%,
primarily due to higher rates partially offset by fewer policy counts. The
decline in policy counts was primarily in the workers compensation line of
business. The decline in premiums earned for personal lines was 7.6%, primarily
due to fewer policy counts partially offset by higher rates. The reduction in
personal lines volume was driven primarily by a planned reduction of business in
certain less profitable states and the implementation of other more stringent
underwriting processes. The
Page 15
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
trend of double-digit percentage growth in commercial lines premiums earned is
expected to continue in 2003 while the decline in personal lines premiums earned
is expected to be much lower in 2003 and may turn positive later in 2003.
Investment income was essentially unchanged for the three months ended
March 31, 2003 as a higher level of invested assets was offset by a lower yield.
Realized investment gains (losses) decreased $0.9 million for the three
months ended March 31, 2003 compared to the same prior year quarter primarily
resulting from greater losses on equity securities partially offset by greater
gains on the sale of fixed maturity securities.
There were no impairment charges in the first quarter of 2003 and $2.4
million of impairment charges in the first quarter of 2002. Harleysville Group
had a gross realized loss of $1.3 million in the first quarter of 2003 which was
from the sale of an equity security which had not declined by more than 20%
below its cost for more than six months at the time of its sale.
Harleysville Group holds securities with unrealized losses at March 31,
2003 as follows:
LENGTH OF UNREALIZED LOSS
-------------------------------
UNREALIZED LESS THAN 6 TO 12 OVER 12
FAIR VALUE LOSS 6 MONTHS MONTHS MONTHS
---------- ---------- --------- -------- -------
(in thousands)
Equity securities $53,578 $11,752 $928 $8,186 $2,638
======= ======= ==== ====== ======
Fixed maturities:
Obligations of state
and political
subdivisions $27,303 $ 275 $159 $ 116
Corporate bonds 34,300 8,100 89 $8,011
------- ------- ---- ------ ------
Total bonds $61,603 $ 8,375 $248 $ 116 $8,011
======= ======= ==== ====== ======
Substantially all of the fixed maturity securities are classified as
available for sale and are carried at fair value on the balance sheet.
There are 26 positions that comprise the unrealized loss in equity
investments at March 31, 2003. While 19 of these positions have been below cost
for more than six months, they have had volatile price movements and have not
been significantly 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 2003.
Page 16
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
There are $33.4 million in fixed maturity securities, at amortized cost,
that at March 31, 2003, had been below amortized cost for over 12 months. These
primarily are comprised of airline enhanced equipment trust certificates (EETC)
as follows:
FAIR MATURITY
COST VALUE DATES
------- ------- -----------
(in thousands)
American Airlines $14,454 $ 9,405 2011
United Airlines 7,002 4,708 2010-2012
Other airlines 2,838 2,487 2011-2015
Other 9,135 8,818 2004-2008
------- -------
$33,429 $25,418
======= =======
After the events of September 11, 2001, air travel and the value of these
airlines' EETC securities declined. The EETCs are all "A tranche" holdings,
which means they are in a senior credit position to the underlying airplane
collateral value as compared to B and C tranche holders. At the time of
issuance, the collateral was appraised at approximately twice the value of the A
tranche EETCs. Recent estimates indicate that in a distressed sale scenario,
the value of the collateral would be approximately the same as the EETCs' cost.
During the fourth quarter of 2002, United Airlines declared bankruptcy. At
March 31, 2003, the United Airlines EETCs continued to carry an investment grade
rating. In the first quarter of 2003, the debt ratings of American Airlines
were downgraded to non-investment grade. Harleysville Group is participating in
certain EETC creditor committees and is monitoring developments. It is possible
that these EETCs may be written down in the income statement in 2003, depending
upon developments involving both the issuers and world events which impact the
level of air travel.
In the first quarter of 2003, Harleysville Group had a loss before income
taxes of $8.9 million, compared to income before income taxes of $16.9 million
in the first quarter of 2002. The decline in income before income taxes of
$25.8 million for the three months ended March 31, 2003, as compared to the same
period in 2002, was primarily due to a greater underwriting loss. The greater
underwriting loss primarily was due to higher property catastrophe losses
resulting from winter storms and an increase in the provision for insured events
in prior years. Property catastrophe losses were $3.6 million and $0.8 million
for the three months ended March 31, 2003 and 2002, respectively. The
Page 17
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
provision for insured events in prior years consists of $20.5 million of adverse
development ($19.9 million in the workers compensation line) and $3.7 million of
favorable development for the three months ended March 31, 2003 and 2002,
respectively.
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 increased to
115.4% for the three months ended March 31, 2003 from 103.3% for the three
months ended March 31, 2002. Such increase was due to a higher underwriting
loss in both commercial lines (including the adverse development in the workers
compensation line) and personal lines.
The statutory combined ratios by line of business for the three months
ended March 31, 2003, as compared to the three months ended March 31, 2002, were
as follows:
FOR THE THREE MONTHS
ENDED MARCH 31,
2003 2002
------ ------
Commercial:
Automobile 96.0% 97.5%
Workers compensation 192.2% 122.0%
Commercial multi-peril 98.8% 100.1%
Other commercial 83.8% 89.8%
Total commercial 114.1% 103.2%
Personal:
Automobile 117.5% 113.5%
Homeowners 124.0% 89.3%
Other personal 114.8% 59.7%
Total personal 119.3% 103.1%
Total personal and commercial 115.4% 103.3%
Page 18
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
The following table presents the liability for unpaid losses and loss
settlement expenses by major line of business:
MARCH 31, DECEMBER 31,
2003 2002
-------- ------------
(in thousands)
Commercial:
Automobile $183,590 $181,537
Workers compensation 253,037 230,705
Commercial multi-peril 252,788 243,312
Other commercial 48,799 47,109
-------- --------
Total commercial 738,214 702,663
-------- --------
Personal:
Automobile 111,070 115,025
Homeowners 40,612 37,768
Other personal 2,410 1,726
-------- --------
Total personal 154,092 154,519
-------- --------
Total personal and commercial 892,306 857,182
Plus reinsurance recoverables 85,455 71,153
-------- --------
Total liability $977,761 $928,335
======== ========
Of the $19.9 million of adverse development in the provision for insured
events in prior years in workers compensation, $16.7 million was attributable to
the 1998 to 2001 accident years and the balance was attributable to other
accident years. Such adverse development represented 8.6% of the December 31,
2002 workers compensation net liability for unpaid losses and loss settlement
expenses. Harleysville Group has publicly noted adverse loss trends in its
workers compensation line for several quarters. These trends are consistent
with the experience of other companies writing this coverage, many of which
have, during the past twelve months, made substantial additions to their
reserves for insured events in prior years in this line of insurance.
Actuarial analysis of the first quarter 2003 loss activity identified
unusually large workers compensation case reserve development occurring in the
month of March. Accordingly, Harleysville Group performed additional analysis
and investigation of the claim activity and concluded that additional reserves
were needed. The change in loss development patterns in the first quarter of
2003 was influenced by a number of factors. The reorganization of Harleysville
Group's claims operations resulted in more proactive claims management which, in
turn, provided more contemporaneous loss estimates. In addition, weak economic
conditions have hampered the ability to return injured workers to employment
thus extending the estimated length of disabilities and medical loss cost trends
have increased.
Page 19
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
Actuarial loss reserving techniques and assumptions, which rely on
historical information as adjusted to reflect current conditions, have been
consistently applied 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 loss reserve
development in other lines of business was not significant and the total $20.5
million of adverse development in all lines represented 2.4% of the December 31,
2002 net liability for unpaid losses and loss settlement expenses.
Because of the nature of insurance claims, there are uncertainties inherent
in the estimates of ultimate losses. The aforementioned reorganization of the
claims operation 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 give rise to uncertainty as to the pattern of future loss
settlements. The frequency of litigation on bodily injury liability cases has
increased during the past two years while the rate of settlement has slowed.
These changed patterns give rise to greater uncertainty as to the pattern of
future loss settlements on bodily injury liability claims. 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 March 31, 2003. For
every 1% change in the estimate, the effect on pre-tax income would be $8.9
million.
The property and casualty industry has had substantial aggregate loss
experience from claims related to asbestos-related illnesses, environmental
remediation, product and construction defect liability, mold, and other
uncertain exposures. Harleysville Group has not experienced significant losses
from such claims.
The personal lines combined ratio increased to 119.3% for the three months
ended March 31, 2003 from 103.1% for the three months ended March 31, 2002. The
increase primarily was due to higher catastrophe losses from winter weather
which affected the homeowners line and higher loss severity which affected each
of the personal lines. Net catastrophe losses increased $2.8 million and losses
ceded under the aggregate catastrophe reinsurance agreement with Mutual
increased $3.7 million for the three months ended March 31, 2003, due to a
greater number and more severe catastrophes in the 2003 period.
Page 20
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
The income tax expense for each of the three month periods ended March 31,
2003 and 2002 includes the tax benefit of tax-exempt investment income of $2.5
million and $2.3 million, respectively.
Liquidity and Capital Resources
Operating activities provided $37.5 million and $24.9 million of net cash
for the three months ended March 31, 2003 and 2002, respectively. The change
primarily is from improved underwriting cash flow, a change in the amount of
realized gains (losses) and a change in the amount of accounts payable and
accrued expenses.
Investing activities used $38.6 million and $23.5 million for the three
months ended March 31, 2003 and 2002, respectively. The increase is primarily
due to an increase in net purchases of fixed maturity investments and an
increase in the purchase of short-term investments.
Financing activities provided $0.7 million of net cash and used $2.1
million of net cash for the three months ended March 31, 2003 and 2002,
respectively. The change is primarily due to an increase in the issuance of
common stock, partially offset by an increase in dividends paid and by the
purchase of treasury stock in the 2003 period.
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 March 31,
2003, Harleysville Group held cash collateral of $137.7 million related to
securities on loan with a market value of $133.5 million. Harleysville Group's
policy is to require initial collateral of 102% of the market value of loaned
securities plus accrued interest, which is required to be maintained daily by
the borrower at no less than 100% of such market value plus accrued interest
over the life of the loan. Acceptable collateral includes cash and money market
instruments, government securities, A-rated corporate obligations, AAA-rated
asset-backed securities or GIC's and Funding Agreements from issuers rated A or
better. 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 collateral held under the securities lending
program and the obligation to return this collateral upon the return of the
loaned securities.
Page 21
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
Harleysville Group Inc. had $10.5 million of cash and marketable securities
and $42.0 million of dividends receivable from its subsidiaries at March 31,
2003 which is available for general corporate purposes including dividends, debt
service, capital contributions to subsidiaries, acquisitions and the repurchase
of stock. The Company's $75.0 million of notes payable are due November 2003;
the Company expects to refinance this indebtedness at or prior to maturity. The
Company has adopted a stock repurchase plan under which the Company and Mutual
may each purchase up to 500,000 shares of Harleysville Group Inc. common stock
up to a total of 1.0 million shares. As of March 31, 2003, the Company had
repurchased 18,499 shares leaving 481,501 shares authorized to be repurchased.
The Company has no other material commitments for capital expenditures as of
March 31, 2003.
RISK FACTORS
The business, results of operations and financial condition, and therefore
the value of Harleysville Group's securities, are subject to a number of risks.
Some of those risks are set forth in Exhibit 13(B) to the Company's annual
report on Form 10-K for fiscal year 2002, filed with the Securities and Exchange
Commission on March 26, 2003.
Page 22
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE
ABOUT MARKET RISK
Harleysville Group's market risk generally represents the risk of gain or
loss that may result from the potential change in the fair value of Harleysville
Group's investment portfolio as a result of fluctuations in prices and interest
rates. Harleysville Group attempts to manage its interest rate risk by
maintaining an appropriate relationship between the average duration of the
investment portfolio and the approximate duration of its liabilities.
Harleysville Group has maintained approximately the same duration of its
investment portfolio to its liabilities from December 31, 2002 to March 31,
2003. In addition, the Company has maintained approximately the same investment
mix during this period.
Page 23
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
ITEM 4. EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
(a) Evaluation of disclosure controls and procedures. Our chief executive
officer and our chief financial officer, after evaluating the effectiveness of
our "disclosure controls and procedures" (as defined in the Securities Exchange
Act of 1934 Rules 13a-14(c) and 15d-14(c)) as of a date (the "Evaluation Date")
within 90 days before the filing date of this quarterly report, have concluded
that as of the Evaluation Date, our disclosure controls and procedures were
adequate and designed to ensure that material information relating to us and our
consolidated subsidiaries would be made known to them by others within those
entities.
(b) Changes in internal controls. Except as stated in the next sentence,
there were no significant changes in our internal controls or to our knowledge,
in other factors that could significantly affect our internal controls and
procedures subsequent to the Evaluation Date. A review of the process of
estimating the case reserves for loss and loss settlement expenses is currently
being conducted and is likely to result in refinements in the procedures for
making such estimates and the internal audit process for compliance with such
procedures.
Page 24
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
PART II. OTHER INFORMATION
ITEM 1. Legal Proceedings - None
ITEM 2. Changes in Securities - None
ITEM 3. Defaults Upon Senior Securities - None
ITEM 4. Submission of Matters to a Vote of Security Holders
The annual meeting of stockholders of Harleysville Group Inc. was held on
April 23, 2003 (the "Annual Meeting" or "Meeting"), with the following result:
The total number of shares represented at the Annual Meeting in person or
by proxy was 28,345,846 of the 30,064,517 shares of common stock outstanding and
entitled to vote at the Meeting.
On the resolution to elect Michael L. Browne, Frank E. Reed and Jerry S.
Rosenbloom as class "B" Directors to serve until the expiration of their
respective terms and until their successors are duly elected, the nominees for
Director received the number of votes set forth opposite their respective names:
Number of Votes
-----------------------
For Withheld
---------- --------
Michael L. Browne 28,303,410 42,436
Frank E. Reed 28,303,961 41,885
Jerry S. Rosenbloom 28,303,365 42,481
There were no abstentions or broker non-votes recorded. On the basis of the
above vote, Michael L. Browne, Frank E. Reed and Jerry S. Rosenbloom were
elected as class "B" Directors to serve until the expiration of their respective
terms and until their successors are duly elected.
The resolution to approve the Amended and Restated Employee Stock Purchase
Plan was adopted, 28,138,811 votes for the resolution, 182,000 votes against the
resolution and 25,026 abstentions.
Page 25
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
PART II. OTHER INFORMATION
(Continued)
ITEM 5. Other Information - None
ITEM 6. a. Exhibits - None
b. Reports on Form 8-K - None
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HARLEYSVILLE GROUP INC.
Date: May 14, 2003 /s/BRUCE J. MAGEE
----------------- -----------------------------------
Bruce J. Magee
Senior Vice President and
Chief Financial Officer
(principal financial officer and
principal accounting officer)
Page 26
CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the Quarterly Report of Harleysville Group Inc. (the
"Company") on Form 10-Q for the period ended March 31, 2003, as filed with the
Securities and Exchange Commission on the date hereof (the "Report"), I, Walter
R. Bateman, Chairman of the Board, and Chief Executive Officer of the Company,
certify, pursuant to 18 U.S.C. section 1350, as adopted pursuant to section 906
of the Sarbanes-Oxley Act of 2002, that:
(1) The Report fully complies with the requirements of section 13(a) or
15(d) of the Securities Exchange Act of 1934; and
(2) The information contained in the Report fairly presents, in all material
respects, the financial condition and results of operations of the Company.
Date: May 14, 2003 /s/WALTER R. BATEMAN
--------------- --------------------------
Walter R. Bateman
Chairman of the Board, and
Chief Executive Officer
A signed original of this written statement required by Section 906 has
been provided to Harleysville Group Inc. and will be retained by Harleysville
Group Inc. and furnished to the Securities and Exchange Commission or its Staff
upon request.
Page 27
CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the Quarterly Report of Harleysville Group Inc. (the
"Company") on Form 10-Q for the period ended March 31, 2003, as filed with the
Securities and Exchange Commission on the date hereof (the "Report"), I, Bruce
J. Magee, Senior Vice President and Chief Financial Officer of the Company,
certify, pursuant to 18 U.S.C. section 1350, as adopted pursuant to section 906
of the Sarbanes-Oxley Act of 2002, that:
(1) The Report fully complies with the requirements of section
13(a) or 15(d) of the Securities Exchange Act of 1934; and
(2) The information contained in the Report fairly presents, in all material
respects, the financial condition and results of operations of the
Company.
Date: May 14, 2003 /s/BRUCE J. MAGEE
---------------- -------------------------
Bruce J. Magee
Senior Vice President and
Chief Financial Officer
A signed original of this written statement required by Section 906 has
been provided to Harleysville Group Inc. and will be retained by Harleysville
Group Inc. and furnished to the Securities and Exchange Commission or its Staff
upon request.
Page 28
CERTIFICATION PURSUANT TO THE SECTION 302
OF THE SARBANES-OXLEY ACT OF 2002
I, Walter R. Bateman certify that:
1. I have reviewed this quarterly report on Form 10Q of Harleysville
Group Inc.;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by this
quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial conditions, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in
this quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: May 14, 2003 /s/WALTER R. BATEMAN
----------------- ----------------------------
Walter R. Bateman
Chairman of the Board and
Chief Executive Officer
Page 29
CERTIFICATION PURSUANT TO SECTION 302
OF THE SARBANES-OXLEY ACT OF 2002
I, Bruce J. Magee certify that:
1. I have reviewed this quarterly report on Form 10Q of Harleysville
Group Inc.;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by this
quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial conditions, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in
this quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: May 14, 2003 /s/BRUCE J. MAGEE
------------------- ----------------------------
Bruce J. Magee
Senior Vice President and
Chief Financial Officer
Page 30