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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 September 30, 2004.
---------------------
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
-------------
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 .
----- -----
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).
Yes X . No .
----- -----
At November 1, 2004, 30,127,684 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 - September 30, 2004
and December 31, 2003 3
Consolidated Statements of Income - For the three
months ended September 30, 2004 and 2003 4
Consolidated Statements of Income - For the nine
months ended September 30, 2004 and 2003 5
Consolidated Statement of Shareholders' Equity -
For the nine months ended September 30, 2004 6
Consolidated Statements of Cash Flows - For the
nine months ended September 30, 2004 and 2003 7
Notes to Consolidated Financial Statements 8
Management's Discussion and Analysis of Results
of Operations and Financial Condition 15
Quantitative and Qualitative Disclosure About
Market Risk 29
Controls and Procedures 30
Part II - Other Information 31
Page 2
Item 1. Financial Statements
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
SEPTEMBER 30, DECEMBER 31,
2004 2003
------------- ------------
(Unaudited)
Assets
------
Investments:
Fixed maturities:
Held to maturity, at amortized cost
(fair value $530,912 and $463,953) $ 509,387 $ 436,521
Available for sale, at fair value
(amortized cost $1,006,747 and $980,936) 1,051,849 1,033,855
Equity securities, at fair value
(cost $110,033 and $97,189) 141,497 137,590
Short-term investments, at cost,
which approximates fair value 94,212 31,411
Fixed maturity securities on loan
Held to maturity, at amortized
cost (fair value $1,530 and $3,532) 1,454 3,092
Available for sale, at fair value
(amortized cost $111,399 and $202,222) 115,564 212,164
---------- ----------
Total investments 1,913,963 1,854,633
Cash 1,037 13,430
Receivables:
Premiums 143,166 140,674
Reinsurance (affiliate $752 and $699) 176,052 164,841
Accrued investment income 21,442 23,086
---------- ----------
Total receivables 340,660 328,601
Deferred policy acquisition costs 103,376 99,033
Prepaid reinsurance premiums 32,442 30,899
Property and equipment, net 21,291 23,824
Deferred income taxes 52,424 43,020
Securities lending collateral 120,888 221,454
Due from affiliate 6,833
Other assets 45,814 65,495
---------- ----------
Total assets $2,638,728 $2,680,389
========== ==========
LIABILITIES AND SHAREHOLDERS' EQUITY
------------------------------------
Liabilities:
Unpaid losses and loss settlement expenses
(affiliate $198,144 and $189,891) $1,280,820 $1,219,977
Unearned premiums (affiliate $51,718 and $52,839) 451,219 437,883
Accounts payable and accrued expenses 82,557 91,999
Security lending obligation 120,888 221,454
Debt (affiliate $18,500 and $18,500) 119,625 120,145
Due to affiliate 16,184
---------- ----------
Total liabilities 2,055,109 2,107,642
---------- ----------
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 31,510,885
and 31,298,532 shares; outstanding
30,112,976 and 29,900,623 shares 31,511 31,299
Additional paid-in capital 160,358 156,997
Accumulated other comprehensive income 45,805 60,450
Retained earnings 370,632 350,844
Deferred compensation (200) (2,356)
Treasury stock, at cost, 1,397,909 shares (24,487) (24,487)
---------- ----------
Total shareholders' equity 583,619 572,747
---------- ----------
Total liabilities and
shareholders' equity $2,638,728 $2,680,389
========== ==========
See accompanying notes to consolidated financial statements.
Page 3
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
For the three months ended September 30, 2004 and 2003
(dollars in thousands, except per share data)
2004 2003
-------- --------
Revenues:
Premiums earned from affiliate (ceded
to affiliate, $188,868 and $182,808) $212,641 $209,177
Investment income, net of
investment expenses 21,499 21,638
Realized investment gains (losses), net 104 (531)
Other income (affiliate $1,755 and $1,844) 4,024 3,838
-------- --------
Total revenues 238,268 234,122
-------- --------
Losses and expenses:
Losses and loss settlement expenses
from affiliate (ceded to affiliate,
$129,248 and $188,437) 153,944 217,456
Amortization of deferred policy
acquisition costs 52,150 51,838
Other underwriting expenses 18,154 18,214
Interest expense (affiliate $100 and $77) 1,587 2,609
Other expenses 2,764 1,596
-------- --------
Total expenses 228,599 291,713
-------- --------
Income (loss) before income taxes 9,669 (57,591)
Income taxes (benefit) 789 (22,937)
-------- --------
Net income (loss) $ 8,880 $(34,654)
======== ========
Per common share:
Basic earnings (loss) $ .30 $ (1.16)
======== ========
Diluted earnings (loss) $ .29 $ (1.16)
======== ========
Cash dividend $ .17 $ .17
======== ========
See accompanying notes to consolidated financial statements.
Page 4
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003
(dollars in thousands, except per share data)
2004 2003
-------- --------
Revenues:
Premiums earned from affiliate (ceded
to affiliate, $553,663 and $531,489) $627,241 $611,761
Investment income, net of investment expenses 64,578 64,734
Realized investment gains (losses), net 12,651 (897)
Other income (affiliate $5,210 and $5,675) 12,259 12,431
-------- --------
Total revenues 716,729 688,029
-------- --------
Losses and expenses:
Losses and loss settlement expenses
from affiliate (ceded to affiliate,
$391,030 and $456,627) 453,765 528,641
Amortization of deferred policy
acquisition costs 153,536 150,053
Other underwriting expenses 57,518 54,892
Interest expense (affiliate $268 and $263) 4,730 5,396
Other expenses 5,449 3,983
-------- --------
Total expenses 674,998 742,965
-------- --------
Income (loss) before income taxes 41,731 (54,936)
Income taxes (benefit) 6,630 (27,110)
-------- --------
Net income (loss) $ 35,101 $(27,826)
======== ========
Per common share:
Basic earnings (loss) $ 1.17 $ (.93)
======== ========
Diluted earnings (loss) $ 1.17 $ (.93)
======== ========
Cash dividend $ .51 $ .50
======== ========
See accompanying notes to consolidated financial statements.
Page 5
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
(Unaudited)
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2004
(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,
2003 31,298,532 $31,299 $156,997 $ 60,450 $350,844 $(2,356) $(24,487) $572,747
--------
Net income 35,101 35,101
Other compre-
hensive loss,
net of tax:
Unrealized
investment
losses, net of
reclassification
adjustment (14,645) (14,645)
--------
Comprehensive
income 20,456
Issuance of
common stock 212,353 212 3,423 3,635
Tax on stock
compensation (62) (62)
Deferred
compensation 2,156 2,156
Cash dividend
paid (15,313) (15,313)
---------- ------- -------- -------- -------- ------- -------- --------
Balance at
September 30,
2004 31,510,885 $31,511 $160,358 $ 45,805 $370,632 $ (200) $(24,487) $583,619
========== ======= ======== ======== ======== ======= ======== ========
See accompanying notes to consolidated financial statements.
Page 6
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003
(in thousands)
2004 2003
---------- ----------
Cash flows from operating activities:
Net income (loss) $ 35,101 $ (27,826)
Adjustments to reconcile net income (loss)
to net cash provided by operating
activities:
Change in receivables, unearned
premiums and prepaid reinsurance balances (266) (43,904)
Change in affiliate balance (23,017) 2,800
Increase in unpaid losses and
loss settlement expenses 60,843 226,013
Deferred income taxes (1,518) (18,745)
Increase in deferred policy
acquisition costs (4,343) (8,038)
Amortization and depreciation 4,017 3,383
Loss (gain) on sale of investments (12,651) 897
Other, net 12,029 (21,269)
--------- ---------
Net cash provided by operating
activities 70,195 113,311
--------- ---------
Cash flows from investing activities:
Fixed maturity investments:
Purchases (157,879) (329,352)
Sales or maturities 151,491 197,253
Equity securities:
Purchases (25,447) (14,674)
Sales 25,064 13,616
Net purchases of short-term investments (62,801) (64,405)
Sale (purchase) of property and equipment (818) 616
--------- ---------
Net cash used by investing activities (70,390) (196,946)
--------- ---------
Cash flows from financing activities:
Issuance of common stock 3,635 8,214
Issuance of debt 100,000
Repayment of debt obligation (520) (475)
Dividend paid (to affiliate, $8,671
and $8,375) (15,313) (15,023)
Purchase of treasury stock (7,497)
--------- ---------
Net cash provided (used) by
financing activities (12,198) 85,219
--------- ---------
Increase (decrease) in cash (12,393) 1,584
Cash at beginning of period 13,430 2,944
--------- ---------
Cash at end of period $ 1,037 $ 4,528
========= =========
See accompanying notes to consolidated financial statements.
Page 7
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 (consisting of
only normal recurring 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, 2003 included in the
Company's 2003 Annual Report filed with the Securities and Exchange Commission
on Form 10-K.
The affiliate transaction disclosures on the face of the financial
statements are in regards to transactions with Harleysville Mutual Insurance
Company (Mutual). Mutual owns approximately 56% of the outstanding common stock
of Harleysville Group Inc. As used herein, "Harleysville Group" refers to
Harleysville Group Inc. and Subsidiaries.
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 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
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.
Stock-Based Compensation
Stock-based compensation plans are accounted for under the provisions of
Accounting Principles Board (APB) Opinion No. 25,
Page 8
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
(Unaudited)
Notes to Consolidated Financial Statements
(Continued)
"Accounting for Stock Issued to Employees," and related interpretations.
Accordingly, no compensation expense is 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 and nine months ended September 30, 2004 and 2003:
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
2004 2003 2004 2003
------ -------- ------- --------
(in thousands,
except per share data)
Net income (loss), as reported $8,880 $(34,654) $35,101 $(27,826)
Plus:
Stock-based employee
compensation expense
(benefit) included
in reported net
income (loss), net of
related tax effects 199 155 253 (301)
Less:
Total stock-based
employee compensation
expense determined
under fair value
based method for
all awards, net of
related tax effects (764) (855) (2,216) (1,940)
------ -------- ------- --------
Pro forma net income
(loss) $8,315 $(35,354) $33,138 $(30,067)
====== ======== ======= ========
Basic earnings (loss)
per share:
As reported $ .30 $ (1.16) $ 1.17 $ (.93)
Pro forma $ .28 $ (1.18) $ 1.10 $ (1.00)
Diluted earnings (loss)
per share:
As reported $ .29 $ (1.16) $ 1.17 $ (.93)
Pro forma $ .28 $ (1.18) $ 1.10 $ (1.00)
Page 9
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
(Unaudited)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
2 - Earnings Per Share
The computation of basic and diluted earnings (loss) per share is as
follows:
For the three months For the nine months
ended September 30, ended September 30,
2004 2003 2004 2003
-------- -------- -------- ---------
(in thousands, except per share data)
Numerator for basic
and diluted earnings
(loss) per share:
Net income (loss) $ 8,880 $(34,654) $35,101 $(27,826)
======= ======== ======= ========
Denominator for basic
earnings per share --
weighted average
shares outstanding 30,063 29,986 29,995 30,017
Effect of stock
incentive plans 90 96
------- -------- ------- --------
Denominator for
diluted earnings
(loss) per share 30,153 29,986 30,091 30,017
======= ======== ======= ========
Basic earnings (loss)
per share $ .30 $ (1.16) $ 1.17 $ (.93)
======= ======== ======= ========
Diluted earnings
(loss) per share $ .29 $ (1.16) $ 1.17 $ (.93)
======= ======== ======= ========
The following options to purchase shares of common stock were not included
in the computation of diluted earnings per share because the exercise price of
the options was greater than the average market price:
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
2004 2003 2004 2003
-------- -------- -------- --------
(in thousands)
Number of options 1,608 1,510 1,608 1,111
===== ===== ===== =====
An additional 803,223 and 1,203,004 options to purchase shares of common
stock were not included in the computation of diluted earnings per share for the
three and nine months ended September 30, 2003, respectively, because their
inclusion would have had an antidilutive effect.
Page 10
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
(UNAUDITED)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
3 - Reinsurance
Premiums earned are net of amounts ceded of $22,051,000 and $66,108,000 for
the three and nine months ended September 30, 2004, respectively, and
$17,129,000 and $51,589,000 for the three and nine months ended September 30,
2003, respectively. Losses and loss settlement expenses are net of amounts
ceded of $13,592,000 and $53,308,000 for the three and nine months ended
September 30, 2004, respectively, and $57,228,000 and $94,734,000 for the three
and nine months ended September 30, 2003, respectively. Such amounts do not
include the reinsurance transactions with Mutual under the pooling arrangement
(described below) which are reflected on the face of the income statements, but
do include reinsurance with unaffiliated reinsurers and the reinsurance
described in the following paragraph. Of the losses and loss settlement
expenses ceded for the three months ended September 30, 2003, $53.7 million is
for losses ceded to involuntary reinsurance mechanisms and reflect increased
estimates of losses on lifetime medical cases. Of this $53.7 million, $48.7
million is ceded to the Michigan Catastrophic Claims Association (MCCA) which
covers no-fault first party medical losses in excess of a retention ranging from
$250,000 to $325,000. Since these ceded losses are above the retention, the
increased estimates had no net impact on results of operations.
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.
Harleysville Group ceded to Mutual premiums earned of $2,164,000 and $2,108,000
and losses incurred of $(440,000) and $(140,000) for the three months ended
September 30, 2004 and 2003, respectively. Harleysville Group ceded to Mutual
premiums earned of $6,424,000 and $6,348,000 and losses incurred of $544,000 and
$4,634,000 for the nine months ended September 30, 2004 and 2003, respectively.
Pursuant to the terms of a reinsurance pooling agreement with Mutual, each
of the insurance subsidiaries of Harleysville Group Inc. cedes premiums, losses
and expenses on all of their respective business to Mutual which, in turn,
retrocedes to such subsidiaries a specified portion of premiums, losses and
expenses of Mutual and such subsidiaries. Because this agreement does not
relieve Harleysville Group Inc.'s insurance subsidiaries of primary liability as
originating insurers, there is a concentration of credit risk arising from
business ceded to
Page 11
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
(UNAUDITED)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
Mutual. However, the reinsurance pooling agreement provides for the right of
offset. Mutual has an A. M. Best rating of "A-" (Excellent).
4 - Cash Flows
Net cash tax payments (refunds) of $(13,709,000) and $1,096,000 were made
(received) in the first nine months of 2004 and 2003, respectively. Cash
interest payments of $6,043,000 and $2,817,000 were made in the first nine
months of 2004 and 2003, 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 FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
2004 2003 2004 2003
-------- -------- -------- ---------
(in thousands)
Revenues:
Premiums earned:
Commercial lines $169,680 $161,412 $495,791 $ 464,279
Personal lines 42,961 47,765 131,450 147,482
-------- -------- -------- ---------
Total premiums earned 212,641 209,177 627,241 611,761
Net investment income 21,499 21,638 64,578 64,734
Realized investment gains
(losses) 104 (531) 12,651 (897)
Other 4,024 3,838 12,259 12,431
-------- -------- -------- ---------
Total revenues $238,268 $234,122 $716,729 $ 688,029
======== ======== ======== =========
Income (loss) before
income taxes:
Underwriting gain (loss):
Commercial lines $(13,517) $(63,953) $(39,523) $(100,726)
Personal lines 344 (13,439) (4,506) (29,181)
-------- -------- -------- ---------
SAP underwriting loss (13,173) (77,392) (44,029) (129,907)
GAAP adjustments 1,566 (939) 6,451 8,082
-------- -------- -------- ---------
GAAP underwriting loss (11,607) (78,331) (37,578) (121,825)
Net investment income 21,499 21,638 64,578 64,734
Realized investment
gains (losses) 104 (531) 12,651 (897)
Other (327) (367) 2,080 3,052
-------- -------- -------- ---------
Income (loss) before income
taxes $ 9,669 $(57,591) $ 41,731 $ (54,936)
======== ======== ======== =========
Page 12
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
(UNAUDITED)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
6 - Comprehensive Income (Loss)
Comprehensive income (loss) for the three and nine months ended September
30, 2004 and 2003 consisted of the following (all amounts are net of taxes):
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
2004 2003 2004 2003
------- -------- -------- --------
(in thousands)
Net income (loss) $ 8,880 $(34,654) $ 35,101 $(27,826)
Other comprehensive
income (loss):
Unrealized investment
holding gains (losses)
arising during period 8,152 (7,510) (6,449) 9,412
Less:
Reclassification
adjustment for (gains)
losses included in
net income (loss) (65) 442 (8,196) 872
------- -------- -------- --------
Net unrealized
investment gains (losses) 8,087 (7,068) (14,645) 10,284
------- -------- -------- --------
Comprehensive income (loss) $16,967 $(41,722) $ 20,456 $(17,542)
======= ======== ======== ========
7 - Pension
Harleysville Group Inc. has a pension plan that covers substantially all
full-time employees. The net periodic pension cost for the plan including
Mutual consists of the following components:
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
2004 2003 2004 2003
-------- -------- -------- --------
(in thousands)
Components of net
periodic pension cost:
Service cost $ 2,007 $ 1,658 $ 5,992 $ 4,975
Interest cost 2,821 2,507 8,361 7,522
Expected return on plan assets (3,101) (2,486) (9,141) (7,457)
Recognized net
actuarial loss 600 13 1,635 38
Amortization of prior
service cost 52 58 157 174
Net transition amortization 14 13 39 40
------- ------- ------- -------
Net periodic pension cost:
Entire plan $ 2,393 $ 1,763 $ 7,043 $ 5,292
======= ======= ======= =======
Harleysville Group portion $ 1,589 $ 1,153 $ 4,658 $ 3,606
======= ======= ======= =======
Page 13
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
(UNAUDITED)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
Harleysville Group contributed $6,600,000 to the pension plan during the
first nine months of 2004 and does not expect to make further contributions
until 2005.
8 - Statutory Capital Requirements
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.
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 2003 statutory financial statements, the ratio of total adjusted capital
to the Authorized Control Level for the Company's nine insurance subsidiaries at
December 31, 2003 ranged from 478% to 609%.
Page 14
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.
Overview
The Company's net income is primarily determined by three elements
including the expenses related to these elements:
- net premium income
- investment income
- amounts paid or reserved to settle insured claims
A number of factors may affect the level of premium income, including:
- limitations on rates arising from the competitive market
place or regulation
- limitation 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
Page 15
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
A number of factors may affect the level of investment income, 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.
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, 2003
included in the Company's 2003 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.
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
Page 16
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
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. 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. The 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 17
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 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 not differ from those assessments.
The application of certain of these critical accounting policies to the
periods ended September 30, 2004 and 2003 is discussed in greater detail below.
Results of Operations
Premiums earned increased $3.5 million and $15.5 million during the three and
nine months ended September 30, 2004, respectively, compared to the same prior
year periods. The increases are primarily due to increases in premiums earned
for commercial lines of $8.3 million and $31.5 million partially offset by
decreases of $4.8 million and $16.0 million in personal lines premiums earned
for the three and nine months ended September 30, 2004, respectively. The
increases in premiums earned for commercial lines were 5.1% and 6.8% for the
three and nine months ended September 30, 2004, respectively, primarily due to
higher rates
Page 18
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
partially offset by fewer policy counts. The decline in policy counts was
primarily in the workers compensation line of business. The declines in premiums
earned for personal lines were 10.1% and 10.9% for the three and nine months
ended September 30, 2004, respectively, 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 decreased $0.1 million and $0.2 million for the three and
nine months ended September 30, 2004, respectively, compared to the same prior
year periods, resulting from a lower yield on the fixed maturity investment
portfolio partially offset by an increase in invested assets.
Realized investment gains (losses) improved $0.6 million for the three
months ended September 30, 2004 due to lesser losses on the sale of equity
investments, partially offset by lesser gains on the sale of fixed maturity
investments. Realized investment gains (losses) improved $13.5 million for the
nine months ended September 30, 2004, primarily resulting from gains on the sale
of two equity securities in the first quarter of 2004.
There were impairment charges of $0.3 million in the three and nine months
ended September 30, 2004 and no impairment charges in the same prior year
periods. Harleysville Group had gross realized losses of $1.2 million and $3.0
million in the nine months ended September 30, 2004 and 2003, respectively,
which were from the sales of securities which had not declined by more than 20%
below their cost for more than six months at the time of their sale.
Page 19
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
Harleysville Group holds securities with unrealized losses at September 30,
2004 as follows:
LENGTH OF UNREALIZED LOSS
-------------------------
UNREALIZED LESS THAN OVER 12
FAIR VALUE LOSS 12 MONTHS MONTHS
---------- ---------- ---------- -------
(in thousands)
Fixed maturities:
U.S. Treasury
securities and
obligations of
U.S. government
corporations
and agencies $ 54,539 $ 411 $ 326 $ 85
Obligations of
states and
political
subdivisions 65,368 1,052 455 597
Corporate
securities 66,593 3,770 731 3,039
Mortgage-backed
securities 30,346 278 278
-------- ------ ------ ------
Total fixed
maturities $216,846 $5,511 $1,790 $3,721
======== ====== ====== ======
Equity securities $ 22,564 $1,741 $1,741 $ -
======== ====== ====== ======
Of the total fixed maturity securities with an unrealized loss at September
30, 2004, securities with a fair value of $131.8 million and an unrealized loss
of $4.6 million are classified as available for sale and are carried at fair
value on the balance sheet while securities with a fair value of $85.0 million
and an unrealized loss of $0.9 million are classified as held to maturity on the
balance sheet and are carried at amortized cost.
There are nine positions that comprise the unrealized loss in equity
investments at September 30, 2004. While two 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 future.
Page 20
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
There are $58.4 million in fixed maturity securities, at amortized cost,
that at September 30, 2004, had been below amortized cost for over 12 months.
Of the $3.7 million of unrealized losses on such securities, $0.8 million
relates to securities which carry A or higher debt ratings and have declined in
fair value roughly in line with market interest rate changes. The remaining $2.9
million of unrealized losses are comprised of airline enhanced equipment trust
certificates (EETC) as follows:
FAIR MATURITY
COST VALUE DATES
------- ------- ----------
(in thousands)
American Airlines $14,365 $12,772 2011
United Airlines 6,949 5,616 2010-2012
------- -------
$21,314 $18,388
======= =======
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.
At September 30, 2004, the American Airlines EETCs carry an investment grade
debt rating and the market value of both issues has improved over the past year.
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 the future, depending upon developments involving both
the issuers and world events which impact the level of air travel.
Income (loss) before income taxes increased $67.3 million and $96.7 million
for the three and nine months ended September 30, 2004, respectively, compared
to the same prior year periods. The increases were primarily due to lesser
underwriting losses and greater realized investment gains. The lesser three and
nine months underwriting loss was primarily due to lower catastrophe losses,
lesser loss severity and a decrease in the provision for insured events in prior
years. The net provision for insured events in prior years consists of $6.1
million and $9.1 million of adverse development for the three and nine months
ended September 30, 2004, respectively, compared to $55.1 million and $76.8
million of adverse development for the three and nine months ended September 30,
2003, respectively.
Page 21
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
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
106.6% and 106.4% for the three and nine months ended September 30, 2004,
respectively, from 137.2% and 119.4% for the three and nine months ended
September 30, 2003, respectively. Such decreases were due to improved
underwriting results in both commercial lines and personal lines, primarily
resulting from the lower loss development and lower catastrophe losses in the
2004 periods.
The statutory combined ratios by line of business for the three and nine
months ended September 30, 2004, as compared to the three and nine months ended
September 30, 2003, were as follows:
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
2004 2003 2004 2003
-------- -------- -------- --------
Commercial:
Automobile 103.8% 131.2% 103.8% 107.8%
Workers compensation 131.2% 203.1% 125.4% 172.4%
Commercial multi-peril 105.8% 134.6% 105.4% 113.3%
Other commercial 103.4% 84.7% 93.5% 82.4%
Total commercial 108.6% 140.1% 106.7% 119.0%
Personal:
Automobile 113.0% 129.2% 114.0% 120.7%
Homeowners 78.3% 129.8% 91.2% 122.2%
Other personal 88.0% 85.5% 103.8% 107.2%
Total personal 99.0% 127.3% 105.3% 120.7%
Total personal and
commercial 106.6% 137.2% 106.4% 119.4%
Page 22
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:
SEPTEMBER 30, DECEMBER 31,
2004 2003
------------ ------------
(in thousands)
Commercial:
Automobile $ 243,009 $ 228,356
Workers compensation 299,028 294,750
Commercial multi-peril 356,883 320,607
Other commercial 66,233 59,042
---------- ----------
Total commercial 965,153 902,755
---------- ----------
Personal:
Automobile 106,579 117,034
Homeowners 38,187 41,264
Other personal 1,714 1,607
---------- ----------
Total personal 146,480 159,905
---------- ----------
Total personal and commercial 1,111,633 1,062,660
Plus reinsurance recoverables 169,187 157,317
---------- ----------
Total liability $1,280,820 $1,219,977
========== ==========
The commercial lines statutory combined ratio decreased to 108.6% and
106.7% for the three and nine months ended September 30, 2004, respectively,
from 140.1% and 119.0% for the three and nine months ended September 30, 2003,
respectively. The decreases are primarily due to lesser adverse development in
the provision for insured events in prior years and lesser catastrophe losses.
The net $9.1 million provision for insured events in prior years for the
nine months ended September 30, 2004 included $6.1 million in the most recent
quarter primarily consisting of $2.7 million from commercial multi-peril, $1.1
million from workers compensation and $2.3 million from other commercial
liability lines. The workers compensation development is due to an estimated
assessment from the National Workers Compensation Pool to reflect its
commutation with a troubled participant. The development in the other lines
reflects loss severity that was higher than the adverse trends noted in previous
quarters. The adverse development was primarily from accident years 1995, 1996,
2000 and 2001, partially offset by favorable development in the 2003 accident
year.
Page 23
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
The $55.1 million of third quarter adverse development in 2003 in the
provision for insured events in prior years was primarily in the following
lines: commercial automobile ($19.1 million), workers compensation ($17.1
million), commercial multi-peril ($13.5 million) and personal automobile ($4.5
million). The remaining $21.7 million of adverse development in the nine months
ended September 30, 2003 was primarily from $19.9 million of workers
compensation adverse development in the first quarter of 2003. Of the
nine-month 2003 adverse development, $67.2 million was attributable to the 1998
to 2002 accident years and the balance was attributable to other accident years.
The adverse development in workers compensation for the nine months ended
September 30, 2003 was $37.0 million. Harleysville Group had publicly noted
adverse loss trends in its workers compensation line for several quarters during
2002 and 2003. These trends are consistent with the experience of other
companies writing this coverage, many of which have, during the past two years,
made substantial additions to their reserves for insured events in prior years
in this line of insurance. The change in loss development patterns in 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.
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 NINE MONTHS FOR THE YEAR ENDED
ENDED SEPTEMBER 30, 2004 DECEMBER 31, 2003
------------------------ ------------------
(dollars in thousands)
Number of claims pending,
beginning of period 8,005 8,900
Number of claims reported 8,187 12,952
Number of claims settled or
dismissed (8,874) (13,847)
------- --------
Number of claims pending,
end of period 7,318 8,005
======= ========
Losses paid $55,361 $ 82,003
Loss settlement expenses paid $11,850 $ 16,465
Page 24
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
Workers compensation losses primarily consist of indemnity and medical
costs for injured workers. The reduction in claim counts reflects the impact of
a reduction in workers compensation exposure as policy counts have declined.
For the nine months ended September 30, 2003, the adverse development in
commercial and personal automobile primarily was due to higher loss severity
trends that became evident in the third quarter when case reserve increases were
recognized. The case reserve increases for commercial automobile primarily
related to adverse legal judgments. Harleysville Group had previously publicly
noted an increase in litigation on bodily injury cases and a slowing of the rate
of settlement. The combination of all of these factors resulted in the
increased estimate of ultimate losses.
For the nine months ended September 30, 2003, the adverse development in
commercial multi-peril primarily was due to higher loss severity trends that
became evident in the third quarter when case reserve increases were recognized.
Like commercial auto, the trend of increased litigation and a slowing rate of
settlement resulted in the increased estimate of ultimate losses. While
Harleysville Group had only incurred $1.5 million of construction defect
liability losses over the past 10 years, it increased its provision for insured
events in prior years by an additional $1.4 million in the third quarter of 2003
for estimated losses on construction defect liability claims because of
increased case activity in that quarter.
Harleysville Group records the actuarial best estimate of the ultimate
unpaid losses and loss settlement expenses incurred and does not determine an
estimated possible range of loss. 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.
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.
Page 25
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
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. 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 September 30, 2004. For every 1%
change in the aggregate estimate across all lines, the effect on pre-tax income
would be $11.1 million.
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 incurred significant losses from such claims.
The personal lines statutory combined ratio decreased to 99.0% and 105.3%
for the three and nine months ended September 30, 2004 from 127.3% and 120.7%
for the three and nine months ended September 30, 2003. The decreases primarily
were due to generally lower loss frequency and lesser catastrophe losses which
affected the homeowners line.
Net catastrophe losses decreased $4.4 million and $7.7 million and losses
ceded under the aggregate catastrophe reinsurance agreement with Mutual
decreased $0.3 million and $4.1 million for the three and nine months ended
September 30, 2004, respectively, primarily due to less severe catastrophes in
the 2004 periods. The three months ended September 30, 2004 includes $6.1
million of losses from weather related catastrophes, primarily four hurricanes.
The three months ended September 30, 2003 includes $9.4 million of losses from
Hurricane Isabel.
The income tax expense for the three and nine months ended September 30,
2004 includes the tax benefit of $2.6 million and $8.0 million associated with
tax-exempt income compared to $2.6 million and $7.7 million in the same prior
year periods.
Page 26
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
Other expenses increased $1.2 million for the three months ended September
30, 2004 primarily due to the write-off of capitalized costs for a software
project that will not be completed.
The insurance industry has recently 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 less than 1% of its premiums through brokers. There are no contingent
commission arrangements with such brokers.
Liquidity and Capital Resources
Operating activities provided $70.2 million and $113.3 million of net cash
for the nine months ended September 30, 2004 and 2003, respectively. The change
primarily is from lesser underwriting cash flow.
Investing activities used $70.4 million and $196.9 million of net cash for
the nine months ended September 30, 2004 and 2003, respectively. The decrease
is primarily due to a decrease in net purchases of fixed maturity investments
due to the decrease in cash provided by operations and by the change in cash
provided by financing activities.
Financing activities used $12.2 million of net cash for the nine months
ended September 30, 2004, compared to net cash provided of $85.2 million in the
same prior year period. The change is primarily due to the issuance of debt 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 September
30, 2004, Harleysville Group held cash collateral of $120.9 million related to
securities on loan with a market value of $117.1 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
Page 27
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
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.
Harleysville Group Inc. maintained $11.1 million of cash and marketable
securities at September 30, 2004 which is available for general corporate
purposes including dividends, debt service, capital contributions to
subsidiaries, acquisitions and the repurchase of stock. Harleysville Group has
adopted a stock repurchase plan under which it may, from time to time,
repurchase up to 500,000 shares of Harleysville Group Inc. common stock. Mutual
has authorized purchases of the common shares of Harleysville Group in an equal
amount. As of September 30, 2004, the Company had repurchased 397,909 shares
leaving 102,091 shares authorized to be repurchased. The Company has no other
material commitments for capital expenditures as of September 30, 2004.
RISK FACTORS
The business, results of operations and financial condition, and therefore
the value of the Harleysville Group's securities, are subject to a number of
risks. Some of those risks are set forth in the Company's annual report on Form
10-K for fiscal year 2003, filed with the Securities and Exchange Commission on
March 12, 2004.
Page 28
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, 2003 to September 30,
2004. In addition, the Company has not significantly changed its investment mix
or market risk during this period.
Page 29
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
ITEM 4. CONTROLS AND PROCEDURES
(a) Evaluation of disclosure controls and procedures. The Company's chief
executive officer and its chief financial officer, based on their
evaluation of the Company's disclosure controls and procedures (as
defined in Exchange Act Rule 13a-15(e)) have concluded that the
Company's disclosure controls and procedures are adequate and
effective for the purposes set forth in the definition thereof in
Exchange Act Rule 13a-15(e) as of September 30, 2004.
(b) Change in internal control over financial reporting. There was no
change in the Company's internal control over financial reporting that
occurred during the third quarter of 2004 that has materially affected,
or is reasonably likely to materially affect, the Company's internal
control over financial reporting except as noted in the next paragraph.
During 2003, the Company reviewed the processes by which case reserves
for loss and loss settlement expenses are estimated and whether those
processes were being consistently applied. These processes are an
important element in establishing aggregate reserves. Management took
steps in 2003 to improve internal controls in this area, including
hiring a new Senior Vice President to manage the claims function,
reducing turnover rates in the personnel engaged in estimating case
reserves and proactively managing the effects of such turnover,
implementing refinements in the processes which the Company follows
in estimating these reserves, and shifting the internal audit of
compliance with these processes from an internal auditor within the
claims department to the Company's regular internal audit group.
Management expects the effectiveness of these internal controls to
continue to improve in 2004 as a result of these actions and, as part
of our normal actuarial review process, will evaluate the impact of
these changes on a regular basis.
Page 30
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
PART II. OTHER INFORMATION
Item 1. Legal Proceedings - None
Item 2. Unregistered Sales of Equity Securities
(c) The Company announced a stock repurchase plan on March 3, 2003.
The Company may purchase up to 500,000 shares of Harleysville
Group Inc. common stock. The plan expires February 26, 2005.
As of September 30, 2004, the Company had repurchased 397,909
shares leaving 102,091 shares authorized to be repurchased. There
was no activity in the plan during the nine months ended September
30, 2004.
Item 3. Defaults Upon Senior Securities - None
Item 4. Submission of Matters to a Vote of Security Holders - None
Item 5. Other Information - None
ITEM 6. a. Exhibits
31.1 Certification of Chief Executive Officer Pursuant to Rule
13a-14(a) of the Exchange Act.
31.2 Certification of Chief Financial Officer Pursuant to Rule
13a-14(a) of the Exchange Act.
32.1 Certification of Chief Executive Officer Pursuant to 18
U.S.C. 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
32.2 Certification of Chief Financial Officer Pursuant to 18
U.S.C. 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
b. Reports on Form 8-K
A Form 8-K dated July 29, 2004 was filed furnishing, under item
12 of Form 8-K, financial results for the second quarter
of 2004.
Page 31
HARLEYSVILLE GROUP INC. AND SUBSIDIARIES
PART II. OTHER INFORMATION
(Continued)
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: November 3, 2004 /s/ BRUCE J. MAGEE
-------------------- -----------------------------------
Bruce J. Magee
Senior Vice President and
Chief Financial Officer
(principal financial officer and
principal accounting officer)
Page 32
EXHIBIT (31.1)
CERTIFICATION PURSUANT TO THE SECTION 302
OF THE SARBANES-OXLEY ACT OF 2002
I, Michael L. Browne, certify that:
1. I have reviewed the quarterly report on Form 10-Q of Harleysville Group
Inc.;
2. Based on my knowledge, this 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 report;
3. Based on my knowledge, the financial statements, and other financial
information included in this 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
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-15(e) and 15d(e)) for the registrant
and have:
a) Designed such disclosure controls and procedures, or caused such
disclosure controls and procedures to be designed under our
supervision, 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 report is being prepared;
b) Evaluated the effectiveness of the registrant's disclosure controls
and procedures and presented in this report our conclusions
about the effectiveness of the disclosure controls and procedures,
as of the end of the period covered by this report based on
such evaluation; and
c) Disclosed in this report any change in the registrant's internal
control over financial reporting that occurred during the
registrant's most recent fiscal quarter (the registrant's fourth
fiscal quarter in the case of an annual report) that has materially
affected, or is reasonably likely to materially affect, the
registrant's internal control over financial reporting; and
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation of internal control over financial reporting,
to the registrant's auditors and the audit committee of the registrant's
board of directors (or persons performing the equivalent functions):
a) All significant deficiencies and material weaknesses in the design
or operation of internal control over financial reporting which are
reasonably likely to adversely affect the registrant's ability
to record, process, summarize and report financial information; and
b) Any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal control over financial reporting.
Date: November 3, 2004 /s/ MICHAEL L. BROWNE
------------------ -------------------------------------------
Michael L. Browne
Chief Executive Officer and a Director
Page 33
EXHIBIT (31.2)
CERTIFICATION PURSUANT TO THE SECTION 302
OF THE SARBANES-OXLEY ACT OF 2002
I, Bruce J. Magee, certify that:
1. I have reviewed the quarterly report on Form 10-Q of Harleysville Group
Inc.;
2. Based on my knowledge, this 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 report;
3. Based on my knowledge, the financial statements, and other financial
information included in this 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
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-15(e) and 15d(e)) for the registrant
and have:
a) Designed such disclosure controls and procedures, or caused such
disclosure controls and procedures to be designed under our
supervision, 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 report is being prepared;
b) Evaluated the effectiveness of the registrant's disclosure controls
and procedures and presented in this report our conclusions
about the effectiveness of the disclosure controls and procedures,
as of the end of the period covered by this report based on
such evaluation; and
c) Disclosed in this report any change in the registrant's internal
control over financial reporting that occurred during the
registrant's most recent fiscal quarter (the registrant's fourth
fiscal quarter in the case of an annual report) that has materially
affected, or is reasonably likely to materially affect, the
registrant's internal control over financial reporting; and
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation of internal control over financial reporting,
to the registrant's auditors and the audit committee of the registrant's
board of directors (or persons performing the equivalent functions):
a) All significant deficiencies and material weaknesses in the design
or operation of internal control over financial reporting which are
reasonably likely to adversely affect the registrant's ability
to record, process, summarize and report financial information; and
b) Any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal control over financial reporting.
Date: November 3, 2004 /s/ BRUCE J. MAGEE
------------------ ----------------------------
Bruce J. Magee
Senior Vice President and
Chief Financial Officer
Page 34
EXHIBIT (32.1)
HARLEYSVILLE GROUP INC.
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 September 30, 2004, as filed with
the Securities and Exchange Commission on the date hereof (the "Report"), I,
Michael L. Browne, 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 based on my knowledge:
(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: November 3, 2004 /s/ MICHAEL L. BROWNE
------------------ --------------------------------------
Michael L. Browne
Chief Executive Officer and a Director
Page 35
EXHIBIT (32.2)
HARLEYSVILLE GROUP INC.
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 September 30, 2004, 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 based on my knowledge:
(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: November 3, 2004 /s/ BRUCE J. MAGEE
-------------------- ---------------------------
Bruce J. Magee
Senior Vice President and
Chief Financial Officer
Page 36